Leverage (not what you think)

I'm talking platform leverage – the sort of leverage you can get in a proxy battle by putting a page like this in front of millions of people, many of whom may in fact own your stock, the week before the meeting, for free:

Or, the leverage in media you can get by interjecting a few weeks before a major global sporting event a "feature" that redirects searches related to that event to content within your own pages (from TechCrunch):

In preparation for the start of the summer Olympics on August 8, Yahoo has added Olympic-themed Shortcuts to its search results. Yahoo Shortcuts serve up contextually relevant content from various Yahoo properties inline within the search results. Now, whenever somebody searches for Olympic results, news, or athletes, different Shortcut widgets will pop up.

Something like this:

or this:

Not that Google won't do the same.

MSNBC has already done a deal to display Olympic video online in a format that is only supported on the Windows Media Centre.

In this insidious arms race the browser (or browsing enabled OS) is the ultimate high ground. Search captures about 50% of internet users each day, but everyone uses a browser. Sneaking in the door as a general purpose tool or service, pretty soon they can begin dictating what you may or may not do or see. Why shouldn't Firefox (or Microsoft, or Apple) release a plug-in or widget this week which will dynamically update the medal counts and serve athlete profiles (and why not video) from some OTHER source which pays them money to do so. Then you won't even need to use a search engine...

I still remember the sense of outrage when Yahoo first began selling the top positions in search results to the highest bidder... it made it that much easier to jump ship when an alternative came along.

(Oh, yes. This post brought to you by Paul Davis at Technology Investment Dot Info.)

On the Prospects for Securitization

A workmanlike piece in the Financial Times, "A re-emerging market?" by Gillian Tett, Aline Van Duyn and Paul Davies gives a cautiously optimistic outlook for the revival of the securitization market.

However, it's a bit disappointing that the article skips over a couple of key elements. The first is that the explosive growth of securitization from 2000 onward could be depicted as cause or effect of a massive, and in retrospect, unsustainable growth in leverage. Some of this gearing is simply not coming back, and one of the places it is probably not coming back to anywhere near its former levels is securitized products.

The second omission is the degree to which regulators anticipate that more financial intermediation will be done on bank balance sheets in the future. That seems a surprising expectation, given that banks need not only to raise equity to rebuild their capital bases, but will presumably require even more capital to support larger balance sheets. Yet it appears to be the view of regulators that a lot of these fancy financial instruments will not come back to their former levels, leaving a greater role for bank intermediation.

The third is that the article neglects to mention the importance of credit enhancement to certain types of securitized products, particularly residential mortgages. As we have noted before, the loss of monoline capacity is a blow to this market. Credit default swaps (the non-bond-insurer type) are costly due to greater caution on behalf of protection-writers. Moreover, with credit default swaps possibly moving to exchanges (centralized clearing could be a first step in this direction), the resulting standardized contracts might also inhibit securitized deal structuring even after credit markets get on a more solid footing.

Nevertheless, the article provides useful data and a window on how various types of securitized products are faring now. The article is lengthy, so I've skipped past the "how we got where we are" bit and focused on the current and forward-looking parts.'

From the Financial Times:

However, the events of the last year have turned this seemingly virtuous cycle into a vicious spiral. Regulators...have ...become aware that a lot more of the original loans were kept on banks' balance sheets than had been thought. "One of the paradoxes of the securitisation crisis comes from the fact that banks held on to significant portions of senior risk [or highly rated bonds] through lending to hedge funds or through liquidity guarantees to off-balance sheet vehicles - and they did so to a much greater degree than regulators would ever have envisaged," Michel Prada, head of the AMF, the French financial watchdog, told the Cannes conference.

Meanwhile, bankers have discovered that "capital efficiency" can create risks: if banks cannot sell bonds to investors and are forced to hold these on their balance sheet instead, they may run short of capital. In the past few months it has become increasingly difficult to sell securitised bonds, because investors have panicked about the opacity and complexity of these instruments and in effect gone on strike.

While rapid innovation in the securitisation market used to make the products seem exciting, it also meant that the sector grew out of control. More specifically, as subprime losses have mounted, investors have discovered that these products are hard to understand, let alone value - partly because the infrastructure for the market is still weak relative to the complexity of the instruments.

This has had a devastating impact. Back in 2006, or the last full year of activity before the credit turmoil, some $1,800bn (£903bn, €1,141bn) worth of securitised products other than government-backed mortgage securities was issued in the US alone - double the level of 2004. So far this year, by contrast, just $100bn of US products has been sold and considerably less in Europe. Activity in the secondary markets for securitised products dried up as well, as investors stopped trading except if forced into a fire-sale....

Oppenheimer has calculated that since 2000, the volume of US mortgage lending financed by securitisations was seven times higher than the level funded by traditional bank loans. Indeed, in 2005-07 alone...

Some bankers see signs of recovery in the secondary markets, where bonds are traded. "The real money is starting to come in now - and it is encouraging that we are not seeing so much distressed selling," Greg Branch, a Deutsche Bank trader, told the Cannes {European Securitization Forum] gathering.

More important, some banks are continuing to create securitised products. Bundles of student loans and automotive loans, for example, are still being repackaged and sold to investors in America, albeit on a smaller scale than before. So, to an even more limited degree, are European and American corporate loans...

In addition, declares a team at JPMorgan Chase, the future remains bright for collateralised loan obligations - a $500bn sector that uses pools of corporate loans, often made to companies with low credit ratings, to back bonds. "Despite the throes of the 'credit crunch', the future of leveraged loan securitisation is solid," it has been telling clients, urging investors to view these CLO products as "a buy".

None of this, however, can dissipate the overall sense of gloom that pervades the securitisation world. In practical terms there are at least three factors undermining securitised finance. One is the widespread loss of investor faith in valuations of securitised products. While investors used to navigate this complex world with the help of credit ratings, the agencies have been forced to downgrade trillions of dollars of debt in recent months, which has badly undermined confidence.

Another problem is the investor base. In recent years some "real money" asset managers, such as pension funds, bought securitised products. However, especially in Europe, a large chunk of demand also came from hedge funds and from off-balance-sheet entities linked to banks.

The banks themselves also bought securities, particularly highly-rated instruments, since regulatory rules made it cheap for them to keep triple-A rated securities on their books. Citibankestimates that banks have accounted for 30 per cent of the triple-A rated market in recent years, while off-balance-sheet vehicles acquired another 20 per cent.

But most of these buyers are currently sitting on their hands. Hedge funds can no longer get cheap credit lines from banks, and many special investment vehicles and conduits have virtually collapsed. The banks are no longer able to support the market, since they have their own balance-sheet woes. "One of our biggest challenges as an industry is how to restore the triple-A investor base for securitisations," says the ESF's Mr Watson. "This isn't just a confidence issue (although that is an important issue) but is an institutional structure issue."

To make matters worse, the securitisation sector faces rising regulatory pressure. Over the past decade, policymakers have generally supported the "originate to distribute" model and, even now, regulators stress that they continue to see its benefits. "Originate to distribute has merits," says Malcolm Knight, head of the Bank for International Settlements in Basel.

However, regulators face growing criticism that they have failed to spot weaknesses in the model - and are scrambling to find ways to curtail some of the wilder excesses. Earlier this year, for example, the Financial Stability Forum - a group of international regulators and central bankers - proposed that banks should post higher capital provisions when they create some securitised products. The FSF is also looking for ways to discourage banks from constantly securitising products, over and over again, as they have often done this decade. "Securitisation in its simplest form is a great innovation," says Imene Rahmouni Rousseau, a senior official at the Banque de France. "But the paradox is re -securitisation. Products such as 'CDO of ABS' create problems because of complexity, lack of trust and misaligned incentives."

Separately, American officials are considering changing the accounting rules to force banks to take many off-balance-sheet vehicles back on to their balance sheets. "The majority of securitised assets are likely to come back on balance sheet," Citigroup analysts say in a recent note. "We doubt that the proposed changes . . . would mean the end of the securitisation market. However, we do have concerns about some of the changes . . . which could potentially require issuers to raise more capital and keep assets on balance sheets."

Optimists in the banking world point out that the securitisation business has rebounded from blows before. Back in the 1990s, for example, many thought that the collateralised mortgage obligation market was almost dead as a result of investor losses and scandals, but it was revived in a new form....

"Straightforward securitisation will come back," says Richard Berner, economist at Morgan Stanley, who predicts that the real attrition will occur at the more complex end of the market, with products such as CDO squared. Or as JPMorgan says in its own CLO note: "For 'new' CLOs it's a case of back to the future: cleaner portfolios, less investor and structural reliance on leverage, and a normalisation of risk-taking all played a part in market recovery after the last cycle."

Still, this new "flight to simplicity", as some bankers dub it, has a catch: when products become simpler and more transparent, they also tend to produce far lower fees than the esoteric instruments that have flourished in recent years. That might be good news for investors; however, it will certainly not produce the bonanzas that bankers - and bank equity investors - have enjoyed in recent years.

A "back to basics" campaign in securitisation may, in other words, also mean going back to old-fashioned, and much lower, bank profits.

You Can Now Track California Burning

I find this simultaneously impressive and a tad repellant (I'm never clear when informed citizenry slips into prurient interest as far as other people's disasters are concerned). Hat tip Jojo.

The state of California now has Google Maps that track fires, although the site dutifully warns visitors that the information is approximate. We can't embed it, but here are some screenshots. This is a macro view (click to enlarge):



In typical Google Maps fashion, you can shift to the area of greatest interest and zoom in and out. Here is a closer look at the Sacramento area:



The site also provides links to news stories and even has a "Cal Fire Incidents News RSS feed".

Stephen Cecchetti Touts Financial Innovation

A comment in the Financial Times, "Our need to sustain the ‘great moderation’,"by Stephen Cecchetti, professor of global finance at Brandeis, set my teeth on edge. I suspect many readers will react the same way.

Let's start:

The US housing market has collapsed, placing severe strains on the financial system and, as a direct consequence, workers and companies are suffering. But the real concern is not that there will be a few quarters with below average real growth – it is that the period of the great moderation may be over.

We have a US financial system that has already been quasi-nationalized even though the credit crisis has at best run only half its course, runaway inflation in many developing countries, rising commodity prices that threaten to wreak havoc on faltering advanced economies and international trade, and grave difficulties in addressing these issues, since they require a coordinated international response and shared sacrifice. But Cecchetti fantasizes that all that is at risk here is the loss of a bit of growth and the financial stability of the last 20 years (oh, if you conveniently forget the steep but short US recession of the early 1990s. Avoiding disaster will be an accomplishment, and it will probably take years to work through a global realignment, particularly a currency realignment.

To continue:

The past 20 years have brought extraordinary prosperity. Growth has risen the world over and this higher growth has come with a remarkable stability. Comparing the 1970s with the most recent decade reveals that the volatility of real growth in the industrialised world has reduced – the standard deviation of real gross domestic product growth has roughly halved

Actually, growth rates were higher in the 1950s and 1960s in the US, albeit with more volatility, so the "great moderation" is not the panacea that its advocates make it out to be.
Back to Cecchetti:

There are a variety of possible explanations for this unprecedented stability. It could be that a modern monetary policy, with its focus on price stability, is less destabilising. Alternatively, information technology has increased the flexibility of companies to adjust production and employment quickly to changes in the business environment. Or, it could be we have been lucky and faced fewer disruptive shocks. There is something to each of these but the one that I put most weight behind is that financial innovation has allowed companies and individuals to smooth consumption and investment in the face of fluctuations in income and revenue.

Thomas Palley has a different theory I find far more persuasive:

[T]here are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.

Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Given this, the Great Moderation could easily come to a grinding halt. Though high inflation is unlikely to return, recessions are likely to deepen and linger.

Palley may be proven wrong about high inflation, given that the loose monetary policy we exported via currency pegs by developing countries is now coming back to haunt us. But note his view is based on the lack of bargaining power by wage earners. Inflation is unlikely to lead to successful demands for increased pay, so it will not reach the level it otherwise would have.
Cecchetti, by contrast, sees wage smoothing (i.e., increased access of wage earners to debt) as a benign, indeed completely salutary, development:

Elementary economics teaches us that smooth consumption paths yield higher welfare than volatile ones. Intermediate economics notes that, in reality, for households to keep purchases smooth from month to month they need savings or access to loans, which many of them do not have. As a result of this constraint, consumption follows income more closely than the simple theory says it should. Advanced economics teaches that financial markets should provide consumption insurance, allowing individuals to borrow and lend, reducing the dependence of current expenditure on current income.

There is a parallel logic for business. Growth should be smooth, even as revenue waxes and wanes. But in reality, cash-strapped companies are forced to curtail investment plans, while cash-rich ones can splurge. Again, borrowing and lending through financial intermediaries should cut this tie, leaving investment and growth smooth.

Dunno about you, but I find the tone a tad condescending. Aside from that, Cecchetti remains entirely in the world of theory, failing to note that increased access to borrowing has led to greater, unsustainable leverage of consumer balance sheets, and a deterioration of corporate credit (roughly half of the US corporate bonds outstanding are now rated junk). Whatever virtues these developments may have had in theory now seem outweighed by disadvantages in practice. What good is two decades of longer expansions with an overall lower growth rate if the price is a US financial crisis and dollar debasement resulting from measures to reduce (in real terms) the value of the debt overhang? The depreciation of the dollar alone makes Americans poorer in global terms, more than offsetting whatever gains the longer growth periods may have produced.

Cecchetti again:

Over the last 20 years we have seen exactly this sort of financial innovation. Securitisation and the ability to separate risk and payment streams have been the keys to the revolution in finance. Active secondary markets for home mortgages, car loans, consumer credit and business lending enable both collateralised and uncollateralised borrowing. This dramatically weakens the link between income and expenditure for households and businesses.

Um, I'd beg to differ about these "active" secondary markets, There are pretty moribund right now. And banks are now taking large credit losses due to the success in temporarily decoupling expenditure from income. This is supposed to be a virtue?

Back to the article:

It is hard to overstate the importance of these innovations. Looking at data for the US economy, in 1985 just over $500bn of the $1,600bn in home mortgages was in pools used to create asset-backed securities. By 2005, total mortgage debt was $9,500bn, of which $7,500bn was used for securities. Mortgage-backed securities went from representing one-third of a small number to more than three-quarters of a large number. Securitisation of consumer credit also went from zero in 1985 to 10 per cent at the start of this decade.

This is meaningless in proving his thesis. You'd need to look at total credit extended via banks through on-balance sheet lending vs. via securitization, and establish that it led to greater lending. I have no doubt it did (securitization is cheaper due primarily to the lack of the cost of holding equity + the cost of deposit insurance) but his paragraph does not prove his point.

We return to Cecchetti:

Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing. After all, pricing a security requires an accurate assessment of the default probability regardless of what that probability may be. Once something can be priced, it can be traded. While we have less data for other countries, there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income. With smoother growth in household expenditure comes less volatile real growth.

Oh, so here he admits to having no proof, merely a "clear sense". And he further assumes the accuracy of pricing. Lordie.

The article once more:

This brings us to the long-run risks posed by the financial crisis. There was a failure to provide sufficient information about borrowers or align the incentives of the loan originators with the investors in the resulting securities. By separating financial instruments into their fundamental pieces the system allowed risk to be bought and sold, allocating it to those willing to take it on for the lowest price.

The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past. As a result growth has been more stable and business cycles have been less frequent and severe.

While we need to clean up the present mess – aligning the incentives of securities issuers and ultimate investors and providing the information they need to price the risks they face – the fundamental innovations should remain. As we think about how to adjust the financial regulatory system, it is important that we do not stop what is going on, just that we do it better. Otherwise, I fear the great moderation will be over.

As Paul Jackson of Housing Wire noted after the downbeat annual meeting of the American Securitization Forum, many of the so-called innovations depended on credit enhancement. And now that some of those risks are better understood than they once were, third-party credit enhancement has become sufficiently scarce and costly so as to greatly shrink the market for securitized credit. Jackson wrote:

While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.

For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.

Since the monolines are no longer in the business of providing credit enhancement for securitized credits (indeed, that business proved to be their undoing), this calls Cecchetti's cheery view that many of these innovations had a viable economic foundation, meaning they "worked" for all the participants. Clearly, they did not (to a significant degree) for some key players (the guarantors plus investors in certain tranches). The problems thus appear more fundamental than bad incentives and incomplete information. This view is confirmed by the fact that the housing securitization market remains dependent on credit enhancement, but now Freddie, Fannie, and the FHA have stepped up, and in toto are now either providing or insuring 90% of residential mortgages.

So much for private sector innovation.....

Guest Post: Does Connectivity in the Financial System Produce Instability?

With the financial system on the exam table, it has been more than a bit troubling, that certain questions are neglected in serious academic/policy debates.

The discussion of possible remedies focuses on regulatory solutions, everything from requiring mortgage brokers to be licensed to increasing financial institution capital requirements and having much greater harmonisation, as the Brtis like to put it, of banking and brokerage firm oversight.

While these measures individually and collectively could be salutary, no one seems to be willing to consider the fundamental question: did the push to facilitate the free flow of capital, both domestically and across borders, play a role in this crisis? For the last 15+ years, the push in policy has been towards increased efficiency, which means lower transaction costs, less supervision, little interest in considering whether so-called innovations benefit anyone beyond their purveyors (Martin Mayer observed that, "A lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.").

It's important to examine this question, because many in this society have come to believe that regulation is bad and ever to be avoided. Yet markets like the equities markets, where participants trade an ambiguous promise anonymously, depend on regulation. Thus, the question should be, "What level of regulation is optimal?" rather than "How much regulation can we eliminate?" The problem with the latter approach is that it can take years for problems to develop, and when they do show up, since the tools to stop them have been thrown away, a full blow crisis has to develop for corrective measures to be implemented.

Some evidence suggests that free capital flows in and of themselves produce instability and crises. A recent paper by Kenneth Rogoff and Carmen Reinhart found that

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Yet the focus of policy has been to increase the cross border flow of funds. Indeed, when the post mortems of this era are in, I suspect the carry trade will be found to have been a major culprit.

Another indicator: as the financial services industry has become increasingly deregulated and boundaries between businesses become blurred or meaningless (fund managers versus brokerage accounts, hedge funds versus proprietary trading desks, investment bank versus commercial bank) bank profitability has fallen and the industry has pushed into higher risk activities to try to compensate. Indeed, not only have overall risk measures risen, but the top banks also appear to be following common strategies. Both behaviors increase systemic risk.

Reader Richard Kline has been pondering this issue in a series of posts (see here, here and here) from a complex systems perspective rather than the traditional finance/markets vantage point. The discussion below summarizes his argument; a fuller treatment can be found here.

As always, your comments very much appreciated.

From Richard Kline:

Is high connectivity in the financial system desirable from the standpoint of stability? Conventional wisdom would largely say, yes; highly connected capital and exchange markets should ‘reduce inefficiencies,’ bring liquid capital to where ‘it is needed,’ and ‘level the playing field.’ Theoretical simulations of high connectivity systems together with related experience from systems design suggest the reverse: raising connectivity or undampening propagation in a system beyond modest levels in either case leads to high systemic asymmetry at best and pervasive systemic instability at worst. Those wishing an extended discussion of the underlying concepts will find it here. The basic concerns follow below.

CONNECTIVITY

Self-modulation occurs in systems with throughput, nodes, and connectivity between those nodes. If considered in idealized form, the financial system in general, and market behaviors in particular can be evaluated in these terms. Capital, debt contracts, futures, and the like could function as throughput, with both velocity V and volume L. Participants can function as nodes; highly dissimilar if large organizations negotiating specific contracts and deals; highly similar if bidders on regulated exchanges. Nodes vary thus both in size S and in the degree to which they behave differently D from each other. Connectivity K is simply the number of links any given node has to other nodes engaged in similar behavior. Both connectivity and differentiation impede throughput flows, but in opposite ways. The more nodes are connected, the more easily capital or information or loss exposure can flow; this is how connectivity is generally conceived in capital
markets, and the reasoning behind open exchanges. The more that nodes, i.e. participants, are similar in form or behavior, that is the less differentiated they are, the more throughput flows. Again, this is the reasoning behind common regulatory regimes, accounting rules, a common currency, etc.

Correlation across a system tends to involve shifts in differentiation D and connectivity K. That is, correlation largely concerns overall similarity of behavior amongst nodes; institutions move the same products, firms compete on price, market participants act in different directions at somewhat different times---or the same direction all at once, and so on. By contrast, modulation across a system tends to involve shifts in throughput, both in velocity V and volume L, but also regarding self-correlation of throughput. That is, modulation largely concerns similarity of form or movement of throughput; bonds are offered at regular intervals near known prices, varying product risks are ‘factored out’ by insurance or hedges, futures contracts channel price movements, and so on. From this perspective, several generalizations follow:

Organization in a system will self-generalize: order ‘flows’ across the nodes in a system inherently as differentiation D per node and connectivity K per node shift. Even if these changes are linear at the level of individual nodes, they are typically nonlinear at the level of the system, and may involve complete state changes with very short thresholds of transformation. Simulations show that even at very low levels of connectivity, K=2 [yes, two connections per highly similar node], systems will constantly if mostly gradually change their overall alignment. At high levels of connectivity, though, systems are prone to frequent, global transformations. Highly connected systems have inherently transient stability, unless otherwise buffered or dampened.

Connectivity K between nodes allows both order and throughput to circulate widely in a system. However, K is often agnostic as to the influences it allows to propagate, so that if changes in K may yield outcomes as intended they can yield and often do yield ones pervasive and unintended.

Differences between parts of a system impede flows across a system, whether flows of order, of throughput, or both. Differences create ‘inefficiencies,’ but they also buffer propagation in a system. Specifically, differentiation D---the extent to which nodes in a system vary in size, composition, and function---buffers node to node flow. Thus, increasing the similarity of participant behavior in markets (lowering differentiation) has the effect of lowering impedance for the same level of connectivity and/or ‘liquidity’ of throughput. If, for example, everyone carries a large balance on plastic and a low balance on passbook, more throughput moves through one part of the financial system, faster, and more easily.

Lowering nodal differentiation D in a system increases ‘efficiency’ in that it lowers buffering of throughput and allows connectivity to propagate order changes in a system. However, this may be at the expense of system stability as the effect may be the same as increasing connectivity K to the degree where system organization becomes chaotic. Residential property owners, developers, property assessors, mortgage originators, the capital markets, and the bond raters once had diverse profit strategies, but gradually they converged toward the fee-for-service, flip the product model of the capital markets. Connectivity increased, and throughput soared. Um, yes . . . .

Background correlation---the mapping of a system to its supporting context---often also serves as a buffer to propagation in a system since the background order is independent of and often resistant to modification by the order of a coordinated system. If the background order is itself highly correlated, though, it may function as a catalyst rather than as a buffer. Program trading in the late 80s where selling out of many portfolios was correlated to a few common background indices is an example. This is an endemic issue in financial markets, where despite being ostensibly buffered by high participant differentiation of behavior they nonetheless become correlated globally to a few background variables.

Systems with pervasive connectivity K amongst nodes have the advantage of being significantly adaptive to external changes. Raising connectivity for a system increases its overall adaptivity. This has been a purpose of just in time ordering, for example. However, such adaptivity is achieved at the expense of stable internal organization since high-K systems are very prone to system-wide changes: they are globally rather than locally adaptive. The auction rate market for municipal bonds was highly adaptive to very small changes in rates and extremely flexible for participants; it adapted globally to the shift in a single parameter, re-sale probability: look at it now.

‘Liquidity’ in a system is a composite behavior (a multi-variate derived state). Not only does throughput vary in velocity V as well as in the ‘headline number’ of volume L, it may modify itself through self-correlation as will be mentioned below. Additionally as per the above description, changes in both differentiation D and connectivity K in a system greatly change how throughput behaves. Where D and K remain generally the same, ‘liquidity’ can be influenced by varying volume or modulating velocity. As we see with the failure of ‘liquidity’ in US capital markets 08, volume and velocity alone are insufficient: the banks have low D---most are functionally insolvent---with decreased K---they little lend to each other. Studies of connectivity imply that in such conditions many minor local optimae develop with low overall systemic flow; just so. Despite large volume capital injection, the financial system remains ‘illiquid.’

MODULATION

Capital of similar form or moving in similar ways across a system of nodes-participants needn’t be reshaped drastically transaction by transaction; rather, it can be disproportionately influenced by small changes to the system which raise or lower impedance to its movement. This is what is meant by modulation. Central bank interest rate setting is substantially a modulation effect. A central bank ‘signal’ is small in relation to overall capital throughput, but even in the absence of legal compulsion that signal forms a value range around which transaction throughput is abundant and moves freely, while defining outlier value ranges where throughput moves poorly and accordingly is scarce.

Independent of connectivity, nodes within a system are not necessarily correlated amongst themselves, or at least not highly correlated. Despite this, throughput in a system---capital principally in the context of the financial system---can become more or less self-correlated. For example, if many different forms or terms of throughput move across nodes, any form which has lower resistance will move over more nodes. If its volume can scale, a larger share of throughput over a larger share of nodes is of the same form. Other forms or terms of throughput most nearly similar may see their velocity, volume, and distribution increase as well. In particular, if and as nodal differentiation decreases, the action of throughput is increasingly similar regardless of where it passes through a system: the throughput in effect self-correlates even if nodes and local connectivities retain significant diversity. Auto-correlative changes do not require overt
external intervention, although in financial markets such throughput convergences are highly profitable if spotted or maximized so external intervention in throughput flows is high and probable. If throughput flows and node differentiation and connectivity influence each other progressively, the process becomes self-modulating.

It is possible that as throughput across such a system becomes increasingly modulated, it can yield a field effect. Field phenomena have low overall resistance to point-source propagation; that is, they can globally reference their order state on a continuous basis. Marginal pricing in markets with good transparency strongly suggest a field order. Individual nodes may wish to diverge from a price point, but resistance from the rest of the market will be high; over any near duration, the field order will reduce the price discontinuity to the field order. Field effects can be modeled by tensors, but their ‘statistical logic’ to use a broad term is distinct from that which follows from the kinds of statistical tools typically used for economic activity. In principle, throughput in a system is likely a tensor field, while the system it is mapped to if nodal may well itself be a scalar field. The concept of capital flows as field phenomena is one
that I cannot prove but which should be studied more closely.

Finally, fields induce flow. Set a price or a volume gradient for capital, and said capital will flow across a system, typically towards high capital density regions. A gradient may thus ‘induce’ illiquid or capital-like assets to shift toward liquid forms, or otherwise to shift their state. Moreover, if throughput is sufficiently high in volume, velocity, or both, it can override, even mask, differences in nodes in the system. In part for this reason, system performance with high throughput will consistently give a misleading view of system stability. Correlation of throughput can by field induction carry flow behavior beyond the structural capacity of existing nodes. Again, large-large reasoning does not hold, especially for field phenomena: small value signals can reference larger flows of throughput which furthermore they do not necessarily transact directly. From this perspective, several generalizations follow:

Self-modulation of throughput in a system in effect simulates increasing connectivity K or decreasing differentiation D because throughput increasingly ‘acts the same’ regardless of its velocity or volume. Viewed from the perspective of connectivity above, systems with self-modulating throughput are less stable than their D and K values would suggest, and can become self-destabilizing: they overshoot.

While self-correlation of throughput is not necessarily bad or good, it can mask relevant distinctions. Consider MBSs, inherently of different quality and risk. However, this throughput had to act the same way to pass down-channel readily, so increasingly it had to ‘look the same.’ Hedges were bundled in, tranches were selectively sliced, and even ratings models themselves progressively tweaked to yield uniform AAA ratings. Self-correlation improved flow, even ‘induced liquidity,’ but this was no virtue from the standpoints of risk assessment or risk concentration. Moreover, MBSs of correlated appearance easily correlated their price declines, regardless of underlying differences in performance.

Dense concentrations of capital may drive other nodes to act increasingly the same way as high connectivity allows their ‘order to flow’ across a system. To the extent that they also modulate capital flows, the impact is not only increased but may be self-enhancing by field functions; in effect, such concentrations inherently propagate their own organizational order. Such order flows are not necessarily either complete, linear, or stable; however, their net effect may be to drive differentiation D down, and increasingly to correlate it. Again, in view of the summary above, this not only creates system asymmetry---i.e. the rich get richer---but lowers system stability: dense concentrations of capital are likely inherently destabilizing. For example, it has recently been identified that globally most central bank rates are negative or very low in real terms regardless of their nominal levels. One interpretation for the driver behind this result maybe that the ‘gravity well’ of US and Japanese real rates---which have both been low or negative since the early 90s for the most part---optimized rates first in closely integrated countries, than in others because smaller currencies with higher rates were more expensive to borrow and re-loan. From that perspective, financial preference steadily shifted to low-rate, high liquidity currencies, the opposite of what monetary policies anticipate: rates could either be higher than local conditions warranted or lower, but the ‘gravity’ of very low US and Japanese rates wouldn’t tolerate a middle position.

Statistical reasoning appropriate for field functions is seldom used in assessing throughput organization in the financial system, leading to misunderstanding of systemic conditions by observers. Stability and instability are not Cartesian plots but matrix distributions. The invisible hand is the beck and grasp of a tensor field; current analysis sees the fingernails on the hand, at most.

Stuart Kaufman. 1993. The Origins of Order.
Christopher Chase-Dunn and Andrew Hall. 1995. Rise and Demise.

[Kaufman’s text is dense but seminal in discussions of systemic connectivity, in this case amongst genes. Chase-Dunn and Hall consider core-periphery relations, a concept from political economy which has different implications from the perspective of systemic connectivity.]

"Money Ruins Everything" (Innovation/Intellectual Property Edition)

Australian professors John Quiggin (economics) and Dan Hunter (law) in a provocatively titled paper "Money Ruins Everything," which is coming out in the Hastings Communications and Entertainment Law Journal, argue that the nature of innovation is changing, and that in turn means that we need to rethink policies and incentives. Specifically, they note that the Internet and cheap personal computing now allows for successful amateur innovation, such as open source software, wikis and blogs, something that is beyond the ken of conventional notions of innovation. They provide some recommendations that are germane in a non-US context, but the detailed background discussion, on the history of innovation, the evolution of intellectual property precepts, and how they break down in certain Internet contexts, are valuable for generalist readers who have an interest in technology.

As a blogger, I don't see what I am doing as innovative; I think of blogging as having much in common with being a pamphleteer in the eighteenth century. To the extent this sort of activity can be classified innovative (as open source software is), it isn't clear that technology will get cheap enough in other fields to allow for amateur experimentation (I doubt if you will ever find an inexpensive particle collider, for instance).

But the article nevertheless makes many worthwhile observations. The piece is very readable but it is 54 pages, so I've excepted some of the key sections.

The authors start by describing how the very idea of innovation has evolved:

But prior to the industrial revolution, innovation was not seen in utilitarian terms and existed largely independent of any market forces.16 Most innovations occurred on the farm or perhaps within the confines of a village as a result of specific needs of the individual and then those nearby, who happened to hear of the innovation and saw that it might be useful to their lives, adopted them.

Sometimes the innovation did come to resemble the modern concept of property in an idea or process—for example, the idea might make its way outward through trade routes, and then other people in different locales commercialize the innovation, and sometimes the idea or process became the centerpiece of a guild or trade association, which protects it as a trade secret. But in the absence of a marketplace for ideas, localization was the norm, and until the industrial era, there was little sense that an innovative idea or concept or expression could be exchanged for anything. Innovation was commoditized, and so there wasn’t even a conception that one needed economic incentives to drive social progress: for example, patents were monopoly rights granted as a reward for services to monarchs, not to encourage invention

The piece continues with the development of notions of property, property rights, and markets, and gives a succinct overview of the theory underpinning our current intellectual property rights regime:

Capitalist societies see innovation as dependent on exclusive property interests. We assume that it is necessary to propertize intellectual activity if we wish to spur creativity or inventiveness. This assumption is based on the fear that the benefits of intellectual activity will be under-produced if it is inadequately commoditized because of public goods and free-rider concerns. For the last two hundred years this model has produced great social benefits and so we reasonably assume that new types of innovations will conform to this model. This model of innovative activity, however, has always under-produced innovations that have significant value but which have not been commoditized within the intellectual property system.

This point has long been recognized in relation to fundamental or “pure” research, where the link between discovery and any commercial application is too indirect to allow propertization. Fundamental research has been analyzed as a public good, that is, a good that is both non-rival and non-excludable. In fact, information is the canonical example of a non-rival good, since making information available to one person does notreduce its availability to others. Rather, if anything, dissemination to one person makes it more available to others. On the other hand, information in general, is not excludable—it can be kept secret or patents and other forms of propertization can restrict its use. The crucial feature of fundamental research is that excludability is either unfeasible or undesirable.....

The dichotomy between fundamental research, considered as pure public good, requiring government provision or funding, and applied development work producing patentable innovations, dominated discussions of innovation policy in the Twentieth Century. These polar alternatives, however, do not exhaust the set of possible modes of innovation, or even define the ends of a spectrum within which other modes can be organized.

Then we get to the thesis:

The central argument of this paper is that, with the rise of the Internet and related technologies, the mode of innovation based on free revealing has become radically more important than it was in the past. It has also shifted in location, taking place primarily in the household sector which, for the purposes of this paper, is taken to include work literally undertaken at home and unofficial work undertaken in the workplace. Within the household sector then, the role of non-commercial motivations is extremely important and under-theorized. Indeed, it is barely recognized. So to understand how innovations occur and what our innovation policy should be, it is necessary for policy makers to recognize that many innovations occur outside of the intellectual property system. Thus, any account of innovation policy needs to consider aspects unrelated to the simple utilitarian incentive model of motivation for innovative production, and the attendant property system that we have created to generate the incentive.

Then to a bold claim:

A profound shift is occurring in assumptions about the production of socially valuable expression...The most significant and largely unrecognized aspect of this change is the way that readers have become writers and how digital technologies remove the need for highly capitalized intermediaries to guarantee the widespread dissemination of content. This is the “amateur collaborative content” movement, and it is the most significant development in content since the development of the printing press.

With all due respect to the writers, the printing press ushered in vastly greater changes than we see today. A simple example: reader reminded me that William Tynsdale, who translated the Bible into English and sought to have it printed and distributed was pursued and eventually captured and executed, since giving the laity access to the Holy Word was seen as a threat to the authority of the Church.

The article argues at some length that commercial motivations don't operate well in this amateur space, and puts considerable emphasis on altruistic motivations. It would have helped if the authors had drawn a clearer line between collaborative efforts, such as open source software and citizen journalism, versus ones like blogs, where there is discrete and considerable output from identified individuals. Indeed, the whole appeal of a blog to readers is the distinctiveness of the author, be it his expertise or access to privileged information, his skill and effort in sifting and presenting interesting information, or simply his writing style. And that does offer the opportunity for revenue generation, as Gawker and the existence of recognized, salaried bloggers like Felix Salmon attest.

The article goes through a number of shortcomings of traditional models, and while not proposing specific mechanisms, makes a cogent case for government support (or let's more politely say encouragement) of amateur innovation (and its use of protected intellectual property):

When selling these [trade] deals to foreign lawmakers, the U.S. intellectual property interests—and the U.S. Trade Representative who acts as their muscle—cannot rely on the same arguments as they might exercise back home. Neither Singaporeans nor Australians nor even Canadians care much about the workers in intellectual property-related jobs in Hollywood, California, Redmond, Washington, or Blue Bell, Pennsylvania. So the rhetoric used relies on a combination of consumer economics (“The Free Trade Agreement means cheaper drug prices and access to new movies”) or simplified Hegelian property theory (“This is our property and we should be allowed to stop others from using it without reimbursement.”). These arguments are hard to resist, and coupled with the threat of U.S. trade sanctions, regularly prevail.

Except in one area: culture. National governments have been successful in applying the rhetoric of cultural protection against the rhetoric of property and commercial innovation. The best example of this is, of course, the French...

The reference to the protection of indigenous cultural industries and local content is one of the few ways in which countries can justify protectionism, and can resist the imposition of U.S.-led free trade in intellectual property laws. For example, in the recent negotiations of the USA-Australia Free Trade Agreement, one of the few areas where U.S. intellectual property interests did not triumph entirely was in local content controls for broadcast television.....

The intersection of cultural policy and innovation policy is extremely important in the era of amateur content production. Poorly capitalized creators create amateur content for motives that are generally not commercial. So they have little desire and no incentive to create massmedia content that appeals to a broad audience.

I need to interject. I think most bloggers would LOVE to reach a large number of people. It isn't that they have no desire to reach a mass audience; I think most recognize their limitations, go where they have something to offer, and hopefully find a sympathetic readership. The conclusion is correct, but the emphasis is a bit off.

Back to the article:http://www.blogger.com/img/gl.quote.gif

This is the source of a great deal of misunderstanding on the part of the mainstream media, which assumes that the numbers of readers or the number of links for a given blog are the only significant metrics of success. Thus, the fact that the most widely trafficked blogs now include some professionally produced blogs from the mainstream media283—where once the most popular blogs were almost wholly amateur—can be misread as in indication that the significant blogs will become professional in time. But this metric ignores the scope of the so-called “long tail” of the readership distribution, that is the 27.5 million blogs which cater to specialized interests ranging from high-energy physics, through advertising, the relationship crises of Judy from Oklahoma City, Oklahoma, and every topic in between. And as the latest Technorati report shows, there is a huge audience for amateur content, especially very localized content.

Why is this important for cultural policy? Amateur content is typically very localized and often small-scale: for example, blogs address issues of niche and geographic interest, and by definition are not mainstream media sources. Amateur content is about having a local voice, reflecting the needs and interests of a local audience. The local scale of amateur content is, or should be, extremely important to the large range of counties (and smaller geographic entities like states and provinces) that are not commercial exporters of content. Places like Canada, Singapore and Australia will never be able to compete with the mass media content produced by Hollywood and Britain for English language content...The same is true for place like Quebec and Côte d’Ivoire for francophone content; or Timor Leste for Portuguese language content....

But amateur content is produced for little cost, and for non-commercial reasons. It does not have the same economic structure
as that which drives the mass media industry. So if these minor places want alternatives to mass media content—and if they want alternatives which speak to their specific interests and needs, and not the needs of Parisiens or Los Angelenos—then they should encourage amateur content production as a matter of local cultural policy.

Encouraging an amateur content movement therefore has important implications for the cultural policy of numerous countries. First, it provides opportunities for self-expression and creative self-development for the citizens of those countries and those populations.... nations have an interest in producing creative individuals who feel empowered to express their creativity. Not only do these people produce creative works that are socially meaningful, their presence is correlated with improved economic activity even in non-creative arenas. Then there is the issue of the audience for this creativity: nations-states clearly Then there is the issue of the audience for this creativity: nations-states clearly have a benefit in having material which reflects the interests and needs of its people. have a benefit in having material which reflects the interests and needs of its people.....Therefore national regulators, who want to produce a vibrant corpus of material that is directed to the ethnic and cultural needs of their people, are much better off encouraging the amateur content producers within their country by intelligent use of their cultural policy.

The forms that this encouragement might take are the ones that we are generally familiar with in dealing with policy. Public subsidy and legal controls are the most obvious candidates. As to the former, the most significant public subsidies should be reserved for the public provision of Internet access, on the basis that it has the biggest multiplier effect on the ability of local content to be disseminated. In some countries and locales this will involve the creation of municipal wifi networks, in other cases it will involve building out net infrastructure in other ways.

As to the latter, taking cultural policy seriously means resisting the “level-playing field” argument which is advanced for the uptake of U.S. intellectual property policy in non-U.S. countries, and recognizing that local bloggers, wikipedians, citizen journalists, open source programmers, amateur musicians, and so on, are generators of significant cultural content. Where intellectual property laws constrain their ability to express their local view these laws should be changed.

Do We Want to Foster Customer Neurosis?

As a resident of New York City, I am acutely aware of the perils of neuroticism. This town is full of it. I am as guilty as anyone, although I try to keep it under wraps. If I wasn't concerned about looking like a control freak in front of clients and friends, I would grill waiters about how dishes were prepared, and issue specific instructions (not that I expect compliance, but one can always hope), And I'm not the worst offender. I's not uncommon for hosts to get calls from dinner party guests telling them what foods they won't eat (and that isn't due to allergies or religious strictures). Entertaining is always fraught, but now menu planning has become a minefield.

How did all these picky eaters come to be? I doubt they were difficult as children (in my day, that wasn't well tolerated). Somehow, advertising, diet fads, and fears about food safety have helped create a vigilant cohort of customers. But how great is the net gain? They may feel they are eating healthier; given the lousy state of nutrition science, it's hard to know for sure. And being that watchful takes some of the fun out of food.

Now consider this new service idea from Springwise, a newsletter that writes breathlessly about "new ideas for entrepreneurial minds":

Mapping the best and worst seats in hundreds of airplanes, SeatGuru is one of our favourite examples of transparency tyranny—the power of detailed information to help consumers find the best of the best and leave the rest behind. So we were pleased to hear about TripKick, a similar venture that's tackling another aspect of travel: hotel rooms. While TripAdvisor (which acquired SeatGuru in 2007) gives travellers access to detailed hotel reviews by other travellers, who occasionally include info on which rooms to book, there's definitely an opportunity in getting specific about individual rooms.

TripKick—"your hotel sidekick"—launched with about 250 hotels in 10 US cities, with more to follow. Coverage of each hotel includes detailed information on which rooms to request: which rooms are oversized (rooms ending in 03 and 04, for example), which have great bathrooms or are quieter than others. TripKick, which spent a year gathering all of this information, also points out which floors are better, and which to avoid. Guests are encouraged to add their own reviews and upload photos of rooms they've stayed in.

Is this much information really empowering, or does having such fine grading merely make some people unhappy when they don't get what their little website says is the best? John Kenneth Galbraith noted that consuming (he really meant shopping) takes effort. This level of shopping is work for perilous little return.

The fallacy of these services is that the difference BETWEEN vendors and classes is much greater than within. A two class plane has worse business class seats than in three class plane, and getting cross country planes that fly international routes too are the best. And even within a grade of service, the vast majority of customers pick a carrier based on some combination of price, schedule, and mileage group preferences. Thus, obsessing about one's seat beyond a few obvious considerations (avoiding middle seats, not being in the back row) takes care of most problems. The rest can usually be solved by earplugs or noise-canceling headphones.

And that goes double for hotels. The difference between a Ritz and a Raddison is greater than the difference in rooms (within the same room category) in a facility in either chain. The very few times I've been unhappy with rooms has been when the problem was endemic to the hotel: chambers as dim as a bar when I needed sufficient light to work (I guess I misunderstood what sort of business customer they were catering to), rooms that were badly in need of refurbishing (unavoidable in Zagreb), or sub par room service. A hotel isn't home; is it really worth fussing about getting the "best" room on the "best" floor?

Now I'll admit that there may be value in seeing the photos of typical rooms if, say, you are planing a vacation stay. Then comfort is a greater consideration. But again, the main benefit is making comparisons between hotels or room grades, not within.

Innovation expert Michael Schrage says that most businesses need to fire 15% of their customers. With services like these fostering generally unproductive fussiness, he may have to raise that threshold.

Guest Post: "Is the Securitization Crisis Driven by Nonlinear Systemic Processes?"

Reader Richard Kline, who provides regular, sophisticated comments, was keen to continue the discussion provoked by a post last week, "Hoisted From Comments: Greater Liquidity Produces Instability." An anonymous reader offered a complex systems theory view of our modern financial system. The opening paragraphs:

Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn't make risk go away, but moves it more quickly from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.

I hope I am not oversimplifying what either the anonymous reader or Richard intend to convey, but the non-linear issue is not trivial. Processes that are described by non-linear equations are unpredictable. That is why, per above, inducing or enabling non-linear behavior is Not A Good Idea.

Worse, non-linear math is really hard, so while lots of mere mortals can model linear processes, it takes high powered skills to deal in non-linear modeling. And you therefore get a second problem: due to computational convenience, most practitioners will try to describe a system using linear models, and if it works well enough in most cases, it gets a go. To illustrate: pretty much every mainstream financial model (Black Scholes, for instance) assumes continuous markets, which simplifies the math. This, for instance, is the origin of the classic fat tails problem. Pretty much everyone knows that models that use a normal distribution underestimate tail risk (the odds of outliers, which in this case is dramatic price rises or falls). Yet the flawed models are still consulted out of convenience (note I am not saying other models aren't used, but the reliance on models known to have fundamental shortcomings is considerable).

Richard has provided a through, thoughtful exploration out of some of the issues. After a general discussion, he sets forth five questions and works through the first one. on innovation (note the discussion ranges far beyond the financial markets). Recall that one of the defenses of our current financial mess is that the products were innovative and hasty regulation will curtain other useful advances (this argument is that the products weren't the problem, it was the practitioners, or in popular terms, "guns don't kill people, people kill people"). But as Richard illustrates, that level of discussion is simplistic; there are ways to parse the problem that can lead to better thinking about possible remedies.

His ideas on issues 2-5 will come in later posts in this series.

Your comments very much appreciated. I've edited his piece slightly to make it a bit less formal.

Now to Richard Kline:

To what extent have nonlinear processes promoted the Securitization Bubble, precipitated its collapse, or prolonged the resulting instabilities in the financial system? I'll keep the discussion non-technical, i.e. non-mathematical. While I have an informed opinion, I don’t pretend to expertise, and hope to elicit further comment and debate.

While there is evidence for most of my contentions, it isn’t conclusive;. I raise ideas more than offer conclusions. Some general, but valuable, further reading is suggested for those interested. Comment by those with technical background in nonlinear complex systems, especially economic systems, is welcome---but I’m not holding my breath. Though nonlinear dynamics in financial markets received no little initial research ten years ago and more, many of the specialists involved have since been hired into the hedge fund industry where their work has presumably become proprietary. Not only do we not know what they are doing, we don’t even know what they know now; there has been little recent publication of consequence.

To delve into this issue, then, let us first briefly consider financial markets as systemic phenomena. Given their inherent complexity and diversity of inputs, modern financial markets are inherently complex systems with numerous nonlinear phenomena embedded within their actions, that is phenomena whose transformations are not smooth, not continuous, or both. Such overlapping dynamical phase spaces appear less complex than they are because salient stable equilibria within them are defined by firm, cohesive, and above all observable parameters such as priced units of exchange, transaction terms, regulatory limits, and the like. Such firm parameters do typically though not invariably have the virtue of precluding overtly chaotic behaviors in their respective financial event-spaces, and to a degree in the larger interaction systems which contain them. Indeed, while complex systems will often self organize with emergent properties developing within them in consequence, the intervention of human participants in these markets tends to limit or swiftly capture observable systemic properties---or at least that is the idea.

Since these defined and manipulated parameters are of lower dimension than the market processes to which they map, they give the illusion to the observer that markets themselves are more solid and of lower dimension than is really the case, like skin on hot chocolate. This illusion is compounded by the fact that the very large volume of quantitative data regarding finance and markets, including trend analyses beloved by academically trained economists, are presented in linear analytic terms; ants crawling on that skin, if you will. Such linear models tell something regarding ‘what dwells below,’ but less then we often lead ourselves to believe.

Bear in mind, though, that such linear models only map to the nonlinear trajectories and higher dimensions of the underlying event-spaces, if with fair reliability, rather than fully describe them. These are fuzzy, noisy spaces in that they largely describe human behavior which is intrinsically inexact, information which can be imperfect and/or corrupt(ed), and rule-parameters which are not always followed and which do not capture all relevant processes. Phase spaces and their properties are best described as geometric structures with a time dimension which describe relationships whereas our analyses in a modern educated context are overdefined by linear mathematical methods which abstract fixed values. The present conceptual mismatch of methods to phenomena further leads to an insufficient cognitive engagement with systemic and nonlinear processes on their own terms, in economic behavior and elsewhere:

Our tools are yet poorly matched to the natural phenomena we wish to understand. I will pose it as a truism that processes which appear disjointed or broadly nonlinear do so when they are viewed from perspectives which are or lower dimensionality than are the structures observed; Flatland views of Squareland trajectories. Tensor analysis may prove sufficient to effectively analyze some complex processes; perhaps. Since most of us cannot execute it competently, nor are the guidelines clear by which to operationalize available data into tensor matrices, we will have to sharpen our ‘complex reasoning’ to make heuristic judgments better suited to the data-events instead. This exercise is valuable in and of itself. It is even more true in considering complex systems than otherwise that as you define your questions you describe the parameter space of your possible answers. So, let’s build some better questions.

From that position, here are five questions recently and variously posed which I find personally interesting:

Does innovation require untrammeled information flow across social/ economic event spaces?

Is the crisis in securitized debt the result of a ‘black swan’ event?

Was the creation of the Securitization Bubble the result of nonlinear processes in the financial markets?

Is a financial event-space optimized for propagation desirable?

If not, what structure or process parameters might improve process outcomes?

Innovation: Does innovation require untrammeled information flow notwithstanding any potential costs to an economy or society of undampened interactive trajectories? Not . . . quite.

The stated assumption that innovation requires untrammeled flows of any kind embeds two misconceptions. First, there is an implied confusion between discovery and innovation. Discovery is just that, finding something not previously understood to exist. Exposure to large bodies of information may raise the probabilities of discovery, but so may improved observation of putatively well-known information. Either way, discoveries are comparatively rare; significant discoveries rarer still.

Second and more fundamentally, the stated assumption conflates innovative design and innovation diffusion. The popular belief is widespread that innovative design results from ‘throwing many ideas up against the wall and seeing what sticks;’ that no one really knows what they are doing so innovative ideas and designs are both essentially fortuitous and random. And certainly fortuitous and random innovations do occur. What is required, then, from this perspective is the largest possible supply of things to throw up against the wall. In fact, much the opposite is the case. To cite Edison’s well-known dicta as a benchmark, “Genius is 1% inspiration and 99% perspiration.” This overstates the case, but innovative design tends to happen in small environments which can be effectively modeled to the point where changes from shifts in composite parameters can be approximated hypothetically, additional variables or inputs can be added to the context in a controlled fashion, or both.

Engagement with those environments---i.e. knowledge and skill---tend to improve the frequency and coherence of designs, to which quality of outcome correlates. Fortuitous manipulations do happen, yes; information putatively extraneous to context can provide valuable guidance or comparison, again yes. Innovative design does not necessarily flourish in noisy environments maximally in flux. There, relationships can be hard to grasp, and innovations may soon be suboptimal in ever changing contexts; indeed, conservative but stable designs may better reward success. In brief, innovative design occurs best in the enriched niche, not in the middle of a crossroads.

Innovation diffusion, by contrast, occurs best where information and adaptation are minimally constrained across a context. Consider the adoption of mobile phones in Europe or Korea, where a single technical standard was publicly designated, adoption of mobiles was rapid and deep, and use-driven development burgeoned. In contrast in the US, competing technical
standards and incompatible service provider networks slowed adoption, and have left services fragmented. Diffusion is a process which implies point autonomous use of what is adopted or put to use. In contrast, propagation is more nearly a spread whose nodes remained linked.

Consider Linux an example of diffusion and Windows an example of propagation. Linux point sources can transform or adapt independently, while Windows point sources are under heavy systemic pressures (incompatibility drift) to transform in relation to nodal (i.e. Redmond) based changes. It isn’t commonly understood that many innovative designs are effected well before they diffuse (or are propagated), perhaps because salient fads can diffuse with great rapidity in modern societies. A typical example is the Internet, which was functionally extant well before software refinements turned it into a mass medium, a medium whose greater scales drove product and organizational developments thereafter. The adoption trajectories of innovations most typically are logistic functions in form, but with longer low adoption under-the-radar initial tails then considered, even much longer. Whether relatively rapid diffusion is a social virtue is debatable, but it is certainly an economic gain if only for implementation investment.

There are two points to making this distinction between innovative design and innovation diffusion (or propagation). First, the two processes can be facilitated or inhibited separately. For example, a society with low barriers to diffusion may still be the one to capitalize upon innovations, regardless of source, because they scale the markets and formalize product parameters. Second, large profits come to those investing in innovations which diffuse due to market scale-ups, while huge profits come to those investing in innovations which propagate since they remain substantially intermediated in subsequent capital flows. The arguments one typically hears for lowering barriers to innovation diffusion and damn the consequences are from those hoping that their innovations or the industries tied to them will get the market scale-up opportunities. ‘Pro-adoptionists,’ to give them a name, typically have a stake in the outcome so their perspective is not disinterested (presuming that anyone else’s could be, either). To get innovative designs we need enriched niches whether or not we have low barriers to innovation adoption. We can have rapid adoption without being particularly innovative. Societies can, in fact, deliberately choose whether or not to have rapid adoption.

Moreover and more importantly societies can deliberately choose which innovations to rapidly adopt (within limits); consider China in the latter regard of selective adoption. Choices about which innovations to permit rapid adoption are choices about who will get very rich, however. Much of the shouting about innovation is, at its base, concerned with the last proposition.

Further reading:

Nebojsa Nakicenovic and Arnulf Grübler. 1991. Diffusion of Technologies and Social Behavior.
Jacob Getzels and Mihalyi Csikszentmihalyi. 1976. The Creative Vision.

[Respectively the best texts on technological innovation and the creative process I have ever
found. Of course they are the least known.]

Microsoft Still Trying Evade the Rule of Law (EU Antitrust Edtion)

Someone needs to tell Microsoft to behave.

By way of background, in December 2004, Microsoft lost its final appeal on an EU antitrust case in which it was found guilty of tying its operating system to its media player, undermining competition and hurting consumer choice, and for failing to give rivals the information they needed to compete fairly in the market for server software, The Redmond company was fined a record $613 million.

To address the server complaint, Microsoft was ordered to license technical information to enable outside companies to design products that would run well on Windows (called API, the application program interface). Note that this isn't a particularly onerous request. Microsoft makes that sort of information available for free except in areas where it is trying to leverage its monopoly.

Microsoft acted in less than good faith through this entire exercise. It appeared to be delaying rather than complying. For example, Microsoft was asked to propose royalties for its API. Now consider Microsoft's response: up to 5.95% of revenues. The EU's technical expert, Neil Barrett, who was recommended by Microsoft, calculated that it would take software companies 7 years to recover their development costs. Now how many products last 7 years? And in particular, how many software products last for 7 years? Cost recovery looks like a fantasy. Barrett determined that even a 1% royalty would be too high, and 0% would be more appropriate.

In September 2007, the European Court of First Instance, in a starkly worded summary read to a courtroom of about 150 journalists and lawyers here, ordered Microsoft to obey a March 2004 commission order and upheld the €497.2 million, or $689.4 million, fine against the company.

In October, Microsoft negotiated a settlement of open items, giving every indication that it would submit to the court's ruling. As the Financial Times reported:

Microsoft finally admitted defeat in its three-year battle with the European Commission on Monday, as the US software giant agreed to comply with the regulator’s landmark finding that it was abusing its dominance of the market.

“I welcome the fact that Microsoft has finally undertaken concrete steps to ensure full compliance with the 2004 decision,” Neelie Kroes, competition commissioner, told a press conference in Brussels. “It is regrettable that Microsoft has only complied after a considerable delay, two court decisions and the imposition of daily penalty payments,” she said.

Under the deal reached between Ms Kroes and Steve Ballmer, the chief executive of Microsoft, early on Monday morning, the company will make it much easier for rivals to use its technology to develop their own programmes.

Microsoft also said it would not appeal the decisive September ruling by the European Court of First Instance, which upheld the Commission’s finding that Microsoft had broken EU competition rules. It ends three years of resistance that has cost €777.5m in fines.

Yet in February, the EU competition commission fined Microsoft $1.4 billion (€899m) for