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Complexity and War or How Financial Firms Wreck Economies for Fun and Profit

There’s a great post up, “Human Complexity: The Strategic Game of ? and ?,” by Richard Bookstaber, former risk manager, author of the book A Demon of Our Own Design and currently an advisor to the Financial Stability Oversight Council. As insightful as it is, Bookstaber does not draw out some obvious implications, perhaps because they might not be well received by his current clients: that the current preferred profit path for the major capital markets firms is inherently destructive.

I suggest you read the post in its entirety. Bookstaber sets out to define what sort of complexity is relevant in financial markets:

The measurement of complexity in physics, engineering, and computer science falls into one of three camps: The amount of information content, the effect of non-linearity, and the connectedness of components.

Information theory takes the concept of “entropy” as a starting point: essentially, the minimal amount of information required to describe a system. Related to this is a measure called thermodynamic depth, which looks at the energy or informational resources required to construct the systemic. The idea is that a more complex system will be harder to describe or to reconstruct, though this is problematic because it will look at random processes as complex; for example, by these sorts of measures a shattered crystal is complex….

Non-linear systems are complex because a change in one component can propagate through the system to lead to surprising and apparently disproportionate effect elsewhere, e.g. the famous “butterfly effect”….

Connectedness measures how one action can affect other elements of a system. A simple example of connectedness is the effect of a failure of one critical node on the hub-and-spoke network of airlines. Dynamic systems also emerge from the actions and feedback of interacting components….

The definition you use depends on the purpose to which you want to apply complexity. For finance, several of these measures of complexity come into play. There are non-linearities due to derivatives. Connectedness comes from at least two sources: the web of counterparties and common exposures. Exacerbating all of these is the speed with which decisions must be made.

So far, so good. Then we get to this:

Also, because economics and finance deal with human-based rather than machine-based systems, our tendency to operate based on context will invariably lead the conventional tools used to solve complex physical systems to miss the mark.

I’m not at all certain that context is the most important driver. What seems to be germane is limited cognitive capacity. Herbert Simon (who Bookstaber invokes elsewhere in this piece, but not on this issue) was keenly interested in the limitations of human intellectual capabilities: that we could only consider a limited number of issues at the same time, that it takes a certain amount of time to access long-term memory, etc. As a consequence, humans are inherently severely reductivist in the way we approach reality. We are strongly disposed towards storytelling as a way to organize information; models are another compensatory device.

Back to Bookstaber:

But another important point for finance which makes complexity differ from its physical counterparts is that in finance complexity is often created for its own sake rather than as a side-effect of engineering or societal progress. It is created because it can give a competitive advantage.


This is arguably true but is actually far too kind to financial firms. “Competitive advantage” implies that they need to offer newer, better, fancier gizmos just as cell phone makers have sought to meet or better yet leapfrog the iPhone. But “better” in terms of market share and appeal to customer, would in many cases imply simpler rather than more complex.

As we wrote in ECONNED:

But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Complexity is central to financial services firm rent seeking. And it is pervasive. It’s not just CDOs or customized derivatives. A credit card agreement in 1980 was one pretty understandable page. With all the relevant sections, they are now thirty often incomprehensible pages.

And the reason complexity is bad is that system-wide, it creates unknown unknowns:

A complex system is one that is difficult to understand and model; as complexity increases, so do the odds of something unanticipated going wrong. This is the driving characteristic of complexity that is most important for finance and economics: complexity generates surprises, unanticipated risk. “Unanticipated” is the key word: it is not simply that more complexity means more risk — we can create risk by walking on a high wire or playing roulette. Rather, it is that complexity increases risk of the “unknown unknowns” variety. And the risks that really hurt us are these risks, the ones that catch us unaware, the ones we cannot anticipate, monitor or arm ourselves against. Simply put, a system is complex if you cannot delinate all of its states. You may think you have the system figured out, and you might have it figured out most of the time, but every now and then something happens that leaves you scratching your head. This is an epistemological interpretation of complexity. It defines complexity as creating limits to our knowledge. Neoclassical economics does not admit such complexity.

If the states in a system can be determined in a sufficiently short time frame, it is not complex, even though doing this may require more analytics and computer power. So complexity is measured by the increased risk of surprising modes of failure and propagation. This means a complex system can be defined as one that cannot be solved, whose effects under stress cannot be anticipated….

We cannot think about complexity without reference to time frame. A problem might be complex if we only have a few seconds to respond, but not complex if our time frame is one or two months. If we have enough time to solve a problem and understand and anticipate all of its possible outcomes, then it is no longer complex even though, to restate the point, it might be costly to solve and monitor, it might have random results (random but where we can know all of the possible states and assign probabilities to each one), but it no longer can lead to surprises.

This importance of time frame is the reason we have to look at complexity and tight coupling jointly. Tight coupling means that a process moves forward more quickly than we can analyze and react….

A second characteristic for complexity in economics, and finance in particular, is that it is not exogenous, simply sitting out there as part of the world. We create it ourselves, indeed often create it deliberately, and create it expressly to harvest the attendant unanticipated risks.

Bookstaber goes from this to argue that game theory is inadequate to describe the resulting interactions because games always have rules, whereas in markets, participants often break rules or understandings (insider trading, securitization sponsors failing to adhere to the terms of pooling and servicing agreements, major banks giving big institutional investors crappy execution on foreign exchange transactions, to barely scratch the surface). He contends that the best model is warfare, which of course appeals to the macho self image that most Wall Street denizens harbor.

But what are the characteristics of war? Unless the engagement is via proxies or a mere skirmish, it involves a serious commitment by both parties, usually so substantial that neither side can readily withdraw (both that it has put its prestige at risk, so that the usual “sunk cost” analyses are put aside, or that withdrawal is tantamount to capitulation and allows the enemy to inflict additional costs (via conquest or a punitive peach treaty) which could be catastrophic, at least as far as the leaders are concerned. War by its nature is potentially a test to destruction. And that is precisely how the banks have played it. And they can escalate their degree of commitment and the damage ultimately done, by virtue of having state guarantees.

So Bookstaber’s analysis provides further confirmation for what we have long said: the only way to allow banks to have their activities backstopped is to have their risktaking severely constrained. They need to be operated like utilities, with extensive regulation and oversight, and excess profits should be seen as probable evidence of rule breaking and investigated. You don’t want a terribly efficient financial system; highly efficient systems are prone to breakdown. Formula One cars only run one (at most) race, and reader vlade reminded us that cheetahs have the same problem:

You’re the fastest meanest thing on earth (and with the least fat), but if you don’t eat for three days, you die.

If a kick from your next meal breaks your leg, you die (of hunger). If you run for too long, you die (of overheating). If you run and can’t rest afterwards, you die (of overheating). If (a lot of things goes here) you die.

Cheetah is sexy, hyena isn’t – but if I was to bet on a long-term survival of one, I’d back hyenas (in fact, a cheetah will give up its kill to a hyena, because it cannot afford any injury in a fight)

The people who are close to the problem, like Bookstaber, keep providing compelling information that we need radically different approaches to managing financial firms than the ones we have now. But it is pretty clear that the officialdom has decided the time for action has past (except in the UK, where an epic battle is underway, much to the consternation of banksters). We can only hope in the wake of the next crisis (because crisis is the inevitable result of the current model) that the nation’s leaders have the will to leash and collar the banks.

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46 comments

  1. nonclassical

    ..having met the gentleman (at the time) who took over New York mosques after Malcolm’s death, I can’t help but recall
    what Malcolm defined, and what he would say today regarding
    Obama’s failures to accomplish “transparency, oversight, accountability”:

    “In the old south there were two kinds of n’s, house n’s, and field n’s”…

    We all know how Malcolm would categorize Obama….

    This is historical documentation-not racism, folks. Our son is named after my dearest Black friend..

    1. youniquelikeme

      @nonclassical… Pointless point and racist remark regardless of who said it and when. (Yves, if you can remove all of my posts for speaking my mind, and leave this one, that is a sad commentary indeed)

    2. Dave of Maryland

      A year ago I had an exchange with a woman about a supposed past life as a Mexican peasant and as the exchange developed I did some careful thinking about house n’s and field n’s and reached some surprising conclusions.

      Field n’s had black mothers and white fathers.

      House n’s had white mothers and black fathers.

      And that was the single distinguishing characteristic of the two groups.

      More I will not say. It was a lot (a lot!) nastier than any derogatory word you can think of.

      1. Strata

        Dave of Maryland, the difference between “House Negroes” and “Field Negroes” was not skin color, their parent’s ethnicity or the form and location of their labor. The difference was a state of mind. Field Negroes were clear-eyed about their exploitation and oppression. Their healthy sense of self led to anger, resentment and if the opportunity arose, escape.

        House Negroes identified with their oppressors to the extent that they were willing to aid in the oppression of others. Their normal posture was supine. They engaged in extensive spying and backbiting on their fellow captives. Their sense of self was nearly non-existent since it was wrapped up in the person of their oppressors.

  2. psychohistorian

    Another great posting, Yves. Thanks for your ongoing efforts.

    I agree with your call for controlling many aspects of banking as a utility. You said, which bears repeating: “They need to be operated like utilities, with extensive regulation and oversight, and excess profits should be seen as probable evidence of rule breaking and investigated.”

    This is true for the communications businesses also. The utility or “bit pipe” service they provide needs to be separated from the “value adding” programming and controls.

    My solution to keeping government evolving as society evolves is to make voting mandatory and “voluntary” social/government service and some level of education mandatory as well. We have shown as a society that we can make progress but then complacency sets in and what was a groove becomes a rut.

    As you said, we can only hope.

    1. Parvaneh Ferhadi

      In essence I agree with the point that banks should be runs as utilities.
      But: TEPCO is a utility too and look what happened.
      That makes me believe that making banks utilities is part to the solution, but isn’t the whole solution.

      You will have to get the profit motives out of these kind of businesses.
      Profits=greed=>Disaster

      1. Dave of Maryland

        Which means utilities must be state-owned. A lot of them used to be, which was the result of excess charges from the 1920’s that led to government takeovers in the 1930’s.

        State constitutions need to be amended to prohibit the sale of state-owned utilities.

        One of the driving forces (one of many, I presume) behind Castro’s revolution in Cuba was extremely high electric rates.

        Which means that state banks are not enough. They need to be chartered in state constitutions themselves.

        But it’s been – what – two years, three years, that state banks have been talked about. Save for North Dakota, is there even one such on the horizon? You would think Alaska and Hawaii (for opposite reasons) would find them attractive.

        1. Parvaneh Ferhadi

          I agree with that too. However, Tschernobyl’ was state owned. The accident there happened during an experiment in which – it is alleged – that key safety systems, especially the Emergency Core Cooling System, were turned off. In addition, the reactor design was declared flawed at some point.
          Just imagine people doing an experiment while turning off key safety systems! Design flaw or not, this is just a bit too risky from my point of view.

          This could lead you to conclude that it doesn’t really matter wheter its private or public, they’ll blow it up anyway.
          But I am not convinced that this would be the right conclusion, since even in state owned entities you find incentives or a system of incentives that could lead to people taking too many risks.

          Of course, I don’t know whether this was the case in Tschernobyl, but it would be interesting to investigate whether the incentive system (official or unofficial) might have induced some people to take to many risks.

          1. ex-PFC Chuck

            As I recall from a post-mortem article that appeared in the IEEE Spectrum a few months after the accident the reactor, which was graphite moderated, had an unstable region fairly low on its power curve. The safety interlocks that were intended to prevent operation in that region were disabled in order to perform tests near that region. I vaguely recall that the tests were being done without proper authorization but unfortunately I don’t recall the specifics. (I’d have linked the article if I had found it.)

          2. Yves Smith Post author

            Do you really think nuclear reactors would be safer if they were regulated as lightly as banks? That’s the benchmark here.

            And nuclear reactors go down as isolated nodes, or in one location, as in Fukushima. One in the US doesn’t go wobbly because one in Europe is in trouble. They aren’t tightly interconnected.

  3. Mark P.

    Interesting post and it’s hard to disagree with its broad conclusions. Because it’s late, I’ll read Bookstaber’s original piece tomorrow.

    However, Yves, if you’re representeding Bookstaber’s position accurately when you write that he “goes from this to argue that game theory is inadequate to describe the resulting interactions because games always have rules,” then Bookstaber doesn’t understand the first thing about game theory.

    Game theory is a field of applied mathematics for analyzing the pay-offs available to an actor or group of actors in any situation where that actor’s or group’s ability to make successful decisions is dependent upon the decisions and actions made by other actors.

    That’s all. Rules — and games, as most people understand games — are precisely NOT what game theory is about.

    For example, according to John von Neumann, game theory’s founder: “Chess is not a game.” (**i. e. not a game in von Neumann’s formulation.**) “Chess is a well-defined form of computation. You may not be able to work out the answers, but in theory there must be a solution, a right procedure in any position. Real games are not like that. Real life is not like that. Real life consists of bluffing, of tactics of deception, of asking what is the other man going to think I mean to do. And that is what games are about in my theory.”

    One simple instance of the kind of game von Neumann _was_ talking about was the game of nuclear brinksmanship that was played during the Cold War between East and West, which was based on the the threat of mutual assured destruction, or MAD.

    As it happens, MAD is an extremely simple game: two players in a zero-sum game (if one player wins, the other loses), with both having the same Pareto-optimal minimax payoff (no first strike/no first strike) in the context of a one-time, non-iterated game (because if either player launches a first strike, both sides are annihilated and it’s game over).

    It should be stressed that game theory assumes neither rationality nor reliable knowledge on the part of actors. Essentially, von Neumann’s and Morganstern’s book, THE THEORY OF GAMES AND ECONOMIC BEHAVIOR (1946) was where the economic dogma that you attack in ECONNED began. But game theory only describes the payoffs available to a rational, utility-maximizing actor; unlike modern economic dogma, it _does not_ assume that actors are necessarily rational or knowledgable. Indeed, rationality is something of a poisoned chalice in certain scenarios.

    The Prisoner’s Dilemma has by now achieved pop culture status as one game theory scenario where being rational doesn’t help the actors.
    http://en.wikipedia.org/wiki/Prisoner's_dilemma

    The Dollar Auction, which is as nifty a model of escalation as exists, is another such scenario.
    http://en.wikipedia.org/wiki/Dollar_auction

    1. vlade

      Indeed, “game” is defined by players, information and moves available to the players and their payoffs (aka p.i.m.p). No mention of rules. Anything goes.

      For simplicity, people often restrict moves, but one of the classical bits is “if you can’t win the game, make it into a different game” – do a move you can do which will re-define the game. That is often the solution to the standard problems like PD, freerider etc. – introduce new moves/information and redefine the game.

      What is often a problem is the response of the others – but to an extent it tries to remove rationality requirement even from there and find an optimal solution regardless of the moves of others.

      Of course, in real life it’s close to impossible to define most of the p.i.m.p elements, which makes the whole problem much harder (and much more fun).

    2. DownSouth

      It should come as no surprise that Bookstaber would attack game theory, as games are used by behavioral economists to try to interject some empiricism and real-life observations into the study of economics.

      The intellectual tradition that informs Bookstaber’s thought runs like a thread throughout our history. As Carroll Quigley observes, it begins with Persian thinking about 600 B.C., came into Classical antiquity through the Pythagorean rationalists, and was given a clear, explicit, and influential statement in Plato’s “Phaedo” about 385 B.C. Although quite incompatible with the Classical outlook, these ideas became increasingly influential and became the generally accepted philosophic outlook after the third century of our era. And as Quigley goes on to explain:

      It was this recourse to rational processes independent of observation that led the ancient rationalists to assume the theories violating Occam’s razor that became established as ‘Aristotelian’ and dominated men’s ideas of the universe until, almost two thousand years later, they were refuted by Galileo and others who reestablished observation and Occam’s razor in scientific procedure.

      Rationalism lost credibility to the scientific method with the advent of William of Ockham’s Nominalist Revolution, which began about 1320 A.D. But the rationalists were not to be outdone. Rationalism was revived by Descartes and Hobbes in the first part of the 17th century. As Michael Allen Gillespie puts it, they “sought to construct a bastion of reason against this terrifying God of nominalism, a bastion that could provide not only individual certainty and security, and not only mitigate or eliminate the incommodities of nature, but also bring an end to the religious and political strife that were tearing Europe to pieces.” “Science, as Descartes developed it in his early thought,” Gillespie goes on to explain, “thus depended crucially on the certainty of intuition.”

      From Hobbes the thread of rationalism runs through Laplace to Adam Smith and Tolstoy and right on down to Bookstaber.

      Two equations one always should keep in mind:

      Rationality = good for elitism

      Scientific method = good for democracy

      As Gillespie explains, the monarchist and royalist Hobbes “developed a science that he believed could eliminate violence, establish peace, and promote prosperity. This science consisted in a physics that described the nature of bodies and the laws governing their motions, an anthropology that described human bodies and their motions, and a political science that established a mechanism to minimize the violent collisions of human bodies.”

      The reason that the statistical mechanics that proved so successful in physics cannot be applied to humans (as Hobbes, Smith and Bookstaber do) is because human beings are not like atoms or molecules. Human beings have a free will. Descartes acknowledged this. Hobbes, Smith and Bookstaber do not. Gillespie goes on to explain:

      Descartes sought to develop an apodictic science that would enable us to understand and control the motions of all bodies. Since humans are only partly bodily, this science could only understand corporeal human processes and had nothing to say about actions deriving from the free will. Descartes’ system of science thus included only an abbreviated anthropology (“The Passions of the Soul”) and did not include social or political science.

      Hobbes’ “science” is built entirely on rationalism, and therefore abhorred the scientific method. As Gillespie points out, “Hobbes also had no sympathy for the [Royal] Society’s Baconian emphasis on experimentation.”

      And so we see this same abhorrence of empiricism and actual observation repeated with Smith and Bookstaber. The reason should be obvious, and that is that their rational creations cannot withstand the scrutiny of observation. This became immediately evident when Smith’s theories were put into practice, as Jean Simonde de Sismondi was quick to pick up on. As Jacques Barzun recounts:

      But he [Sismondi] also urged factual observation in what he was the first to call “the social sciences”; and when the “Encyclopedia Britannica” asked him for an article on political economy, further thought and documentation led him to question the validity of liberal economics. He thus became the first, and for a long time the only, heretic among Smith’s disciples…

      Sismondi had visited England and had been struck by the misery resulting from industrial progress. Why did the seemingly beneficial production of goods by machinery bring on “poverty in the midst of plenty”? The answer was: free competition keeps wages low, free enterprise makes for overproduction, which leads to recurrent “crises”—-shutdowns or failures entailing unemployment and starvation.

      His detailed criticism of the new society includes the observation that it splits labor from capital and makes them enemies, with the power all on one side. The idea of their “bargaining” over wages is absurd. Tyrant and victim describes the relation, yet without cruel intent of the one or knowledge by the other of who his oppressor is. Again, with overproduction the capitalist must seek foreign markets and precipitate national wars, while at home a class struggle goes on without end: “the poor could say that the employer’s life is their death, and therefore his death would be their life.”

      We have to ask why it is that rationalism always seems to prevail over the scientific method. The reason I believe is that there are powerful interests that promote rationality and denigrate the scientific method. Here I believe Quigley gives some important insight:

      We have already mentioned that these Pythagorean ideas held and propagated by Socrates, Plato, Xenophon, and others were not tenable because long before, while Pythagoras was yet alive, one of his disciples had used the master’s own Pythagorean theorem to prove that space was irrational (because it was a continuum). This means that it was possible to prove the irrationality of reality by purely rational (mathematical) arguments and that, accordingly, the fundamental assumption of this school about the rationality and logic of reality was false. Such a discovery should have lead any honest seekers after truth to abandon this fundamental assumption about reality and to fall back on some other assumption (such as the scientists’ assumption that the senses do give us information about reality).

      The continued adherence by the rationalist school to beliefs they knew were false can only be explained on the ground that they had an interest in these beliefs beyond their devotion to truth. Naturally this interest was not stated by these people publicly. At least, no such statement appears in the ancient evidence; so once again we must rely on inference: the key to the thinking of the Pythagorean rationalists lies in their fear of change and hatred of change. Beyond the ordinary change of the physical world they saw the social change that, for centuries, had been spreading political power and economic benefits wider and wider. There can be no doubt that the Pythagorean rationalists resented these political and social changes and wished to deny the possibility and reality of change. Pythagoras himself was the founder of an international oligarchic conspiracy, the Pythagorean Brotherhood, which operated out of Croton, in southern Italy, until it was forced to flee from that city by a democratic uprising about 510 B.C. Thereafter this organization centered in Thebes in Boeotia. In international affairs it operated in support of the oligarchic states and in opposition to the democratic states, like Athens. In intellectual matters it attacked Ionian Science, the sophists, the philosophic nominalists, and the upholders of democracy and of human equality.

      1. Yves Smith Post author

        I think it’s fair to criticize behavioral economics. The work, while interesting, is all in pretty artificial lab settings. And economists tend to tout it as a shiny new toys that renders them immune to criticism of not being empirical.

        Economists hate doing fieldwork. They are allergic to investigation in the real world and are terrible at primary research the few times they endeavor to do it.

        The most insightful guys IMHO are the info asymmetry types.

        1. DownSouth

          I went and read Bookstaber’s post on behavioral economics. He and I certainly have different definitions of behavioral economics. He says “the bulk of this field [behavioral economics] consisted of cataloging behavior deemed aberrant and anomalous. That is, the underlying assumption was that the economic view of [neoclassical] decision making is the correct one, and the [behavioral] economists need to see where people get it wrong.”

          This is hardly my idea of behavioral economics. On the contrary, it is more in line with what Antonio Rangel is doing. As Bookstaber explains, he “is looking to how the brain lights up when various problems are posed to subjects.” I assume he’s talking about using neuroscience to measure electrical and chemical brain activity when people are subjected to various stimuli, or are playing games. This is what I define as the leading edge of “behavioral economics.”

          My real disagreement with Bookstaber, however, isn’t over this difference in nomenclature. Where we disagree is that I don’t buy into the P-utility maximization viewpoint. I reject this as the be all and end all of human existence. But Bookstaber never questions this assumption.

          Instead, Bookstaber focuses on the method people use to optimize. He argues that people can use heuristics instead of logic, math and probability in achieving optimization. But optimization is still the goal. So while Bookstaber pecks around at the edges of neoclassical economics, he really doesn’t go for the juggler, which is that people are P-utility maximizers.

          So what’s the evidence that people are P-utility maximizers? Bookstaber never offers any. So Bookstaber is not using scientific method here, but rationality. Michael Allen Gillespie explains:

          All of this is encapsulated in one of the alternative forms of the razor: one should affirm no statement as true or maintain that something exists unless forced to do so by self-evidence, that is, by…experience…or a logical deduction from…a proposition verified by observation.

    3. DownSouth

      Mark P. said: “…Bookstaber doesn’t understand the first thing about game theory.”

      While that’s certainly a true statement, I think Bookstaber achieves quite a feat in that he seems to understand even less about war than he does game theory.

      It’s instructive that Bookstaber’s ideal warrior is the WWII fighter pilot John Boyd. When I was reading Bookstaber’s post the image that popped in my mind was this one of George Bush dressed up in a flight suit. We all know how that shock and awe worked out in Iraq.

      The sort of conventional war, and in fact the entire war system symbolized by these fighter aces, are now obsolete. They were rendered obsolete by nuclear weapons, people’s war and the method of nonviolence.

      A Prussian officer, for instance, serving with the French penned a lamentation of a kind that was on the lips of many a subsequent soldier sent to fight a guerilla opponent. “Wherever we arrived, they disappeared,” he complained, “whenever we left, they arrived—-they were everywhere and nowhere, they had no tangible center which could be attacked.” The pitched battle, which was the centerpiece of conventional war, was simply sidestepped in people’s war. Rather than seeking to win battles, the people in arms sought mainly to endure. A French captain who accompanied Napoleon in Russia, where his army, in addition to facing the Russian winter, was harassed by guerilla bands, said, “Every victory is a loss to us”—-a saying that the historian of guerilla war Robert B. Asprey has called “a book of wisdom in a single sentence.”

      Probably even more devastating to the sort of competition and pitched battle that Bookstaber relishes is the method of nonviolence. As Alfie Kohn explains in this documentary film(beginning at minute 55:10), these competitive strategies have been found to be highly dysfunctional:

      Competition builds character. In fact, what we find is that by any reasonable notion of character, in terms of psychological health or self esteem, that competition undermines that and creates a kind of neurosis because we come to think of ourselves as good and competent only to the extent that we have defeated other people. And so we’re always playing this desperate king-of-the-mountain game where we’re all worried about triumphing over other people and stepping on their faces and looking at them as if they’re going to step on our faces. That has two effects. One is it’s horrible for us in terms of psychological development because there’s a perpetual sense of dis-ease and anxiety. Second, it very logically has a destructive effect on our relationships.

      We compete because we’re raised that way, not because we’re born that way. Take, for instance, the belief in “survival of the fittest,” which is seen as a Darwinian notion. In fact, Charles Darwin never even used the phrase “survival of the fittest.” That was coined by a right-wing social thinker in the 19th century named Herbert Spencer who tried to corrupt Darwin’s thinking into his own reactionary political purposes. What Darwin talked about was natural selection, which means that the individual organism that’s best able to adapt to a changing environment is more likely to be around to survive and reproduce. Well that doesn’t specify competition as a mechanism. In fact, often the active avoidance of competition, if not the deliberate pursuit of cooperative strategies, turns out to make it more likely that organisms or entire species will survive.

      The research consistently shows that competition not only isn’t necessary for excellence, but tends to impede excellence on most tasks, and the more challenging the task, the more ingenuity and problem-solving skills it requires, competition tends to disrupt that achievement. Excellence pulls in one direction and competition pulls in another.

      And in fact another kind of research study corroborates that. If you take a whole bunch of people and give them a task to do, some kind of problem to work out, and half of them are told “see if you can figure out how to do this task,” and the other half are told “this is a contest with a prize to whoever wins, whoever does the best job,” study after study after study, across cultures, across gender, across ages, find that the people who compete, who have to compete, end up doing an inferior job on that task.

      At the moment, it appears that much of what happens in schools in North America is really for the convenience of people who have most of the power. There is if anything an act of discouragement of critical questioning. Corporations claim they want kids who are able to think outside the box, but only so far as they’re caught within a larger box. That works to the advantage of the free market, which means that the market economy, based on competition, based on economic rather than human considerations, ends up controlling the system.

  4. craazyman

    I have worked as a researcher/writer/consulant/staff mentor with an electric utility industry organization since 2003 and it is quite impressive how well that industry works.

    There’s a good balance between the interests of shareholders, bondholders, management. customers (industrial, commercial and residential) and society at large — due mostly to generally enlightened state regulatory supervision and federal regulation.

    Utilities get kicked around a bit — kind of like the MTA in New York when subway fares go up — but if you really think about it, the industry does a pretty good job making electricity a low-cost, safe, reliable source of energy. There is very little drama when it comes to your utility service and utility bill. You mostly just flip the switch and it all just goes. And when it doesn’t go, the utility’s butt gets kicked.

    Society would benefit tremendously if aspects of utility regulation were adapted to and imposed on banking. The industry could still make big enough profits to give reasonable men and women good, prosperous careers.

    Mr. Bookstaber’s analytical framework is erudite and well-intentioned, but I think it thins itself through somewhat misplaced reductivism into a arid cloud of quasi-metaphysical word-game abstractions and operands that serve unintentionally, to some degree, to prop up the notion of “who could have known” things would crash and burn. And in so doing, it becomes an unintended drapery that covers the marble statue’s tits and butt. bowahahahahahaha. Best just to look at what’s really there and call things by their proper names.

    I’m not sure there really were that many “unanticipated risks” where the systems “effects under stress cannot be anticipated.” That may be true from the perspective of neoclassical economics, but for the higher level of analytical thinking called common sense, it seems a bit precious. Although I suppose this form of vernacular is necessary to pry open certain types of minds, who are so accustomed to framing their thoughts in quasi-scientific jargon that plain words don’t have the prestige to reach through to them.

    1. liberal

      “Utilities get kicked around a bit — kind of like the MTA in New York when subway fares go up — but if you really think about it, the industry does a pretty good job making electricity a low-cost, safe, reliable source of energy. There is very little drama when it comes to your utility service and utility bill. You mostly just flip the switch and it all just goes. And when it doesn’t go, the utility’s butt gets kicked.”

      Not true of PEPCO, operating in Montgomery County, MD. A mouse farts here and the power goes out.

  5. Andrew Bissell

    Why is it now a foregone conclusion that the banks should have their activities backstopped?

    1. Yves Smith Post author

      I’m not saying “should” but “do”. They do have their activities backstopped. The resolution procedures in Dodd Frank will work only with a a purely domestic, non-deaer bank (one without a lot of counterparty exposures). The Fed has even written papers calling not only for the mortgage market to be backstopped (!) but ALL asset backed securities (!!).

      The regulators will pretend they are willing to let a big dealer fail until the next crisis comes.

  6. Yearning to Learn

    I enjoyed the article, it is near and dear to my heart.

    Several years ago (around 2007 I think) when I used to post over at Calculated Risk, I often discussed a problem I termed “peak complexity”, named in part because peak oil was such a big topic back then.

    as life becomes more and more complex, the individual actors do not have the ability to make the required decisions based on the amount of information.

    It is clearly a major problem in most fields of life, but especially politics and finance.

    if I recall, Buffet said there are about 750,000 pages one must read and understand to evaluate some of the contracts that were floating around at the time… one reason why he termed derivatives “weapons of financial mass destruction”.

    same thing in politics. The bills that come out of there these days are so complex that the Congress people can’t even read them before they vote. they have Jr staffers try to parse the bills and give the voting member the Cliff notes. Of course, they are so complex the Congress people rely then on lobbyists and insiders.

    it’s been how long and people are still trying to figure out what Obama care means!

    and there is no question this peak complexity is being used to obfuscate.

    my only qualm: part of the problem with all of this is the desire for Western economies to try to make economics into a science. It is not and can never be. It is a so-called “social” science, heavily influenced by individual and mass psychology.

    thus, we should hesitate to compare our economies to machines or other natural phenomena that really do have background mathematical formulas.

    we should compare them to mental health patients instead IMO.

    1. Francois T

      it’s been how long and people are still trying to figure out what Obama care means!

      and there is no question this peak complexity is being used to obfuscate.

      There is a recent empirical proof of that; Rep Alan Grayson introduced several bills that went absolutely nowhere. The common characteristic of all these was their extreme simplicity. One on health care for all had 4 (!!) pages.

      Regardless of the merits of each individual bills, I’m willing to bet that his colleagues decided right off the bat that these were going nowhere. The reason is rather simple: you can’t hide goodies, tax breaks and bennies for the donor’s class in a 4 pages bill.

      As long as a bill does not answer the question “What’s in it for me?” in a positive manner, that’s it! Everyone will shake their head while commiserating the bill’s author: “It could have been a good idea but…”

    2. Boltzmann's Demon


      “peak complexity”, named in part because peak oil was such a big topic back then.

      as life becomes more and more complex

      Are more of complexities merely coming to light as we gain the leisure to examine these emerging entanglements? Merely coming to light but not becoming more entangled? As our leisure is providing us chance to disentangle will these complexities be simplified thus relegated to lie with curios of a past era? ¿Quien Sabe Kilo Swami? ONe thing for sure, “Ives Herself has been instrumental for the renaissance of Bloggville”. Is this the classical era of blogging? Is Ives thus the driving force of the new classics? The classics are dead — long live the classics!

      ?

  7. Tom Crowl

    I’ve been thinking about these things for a while. Over two years ago I wrote the following as part of laying out the rationale for what I believe is a needed SIMPLE financial innovation.

    Civilization, Complexity & Collapse – The Search for Levers>/a>

    While one would hope that it would be the role of governments to protect both the Commons as well as the rights of the individual, there seems to be considerable problem accomplishing that.

    My believe is that part of the reason for that is an imbalance in the forces impinging on the decisions governments make… (there’s never a perfect balance nor a perfectly wise constituency; however our problem here is unaddressed systemic imbalances which become self-reinforcing with no mechanisms for correction…

    So an additional reason is the lack of any powerful institutional structures with both the will and the capability to check those influences.

    I also believe there are problems with banking and would like to see some more broadly-held structure capable of competing for some of those functions.

    Hence the concept of the Commons-dedicated Account under some sort of universal ownership…

    The viability for such a concept centers around reducing transaction costs in particular areas to facilitate needed activity in those areas (e.g. networked citizen lobbying via a viable micro-transaction) by achieving monetization elsewhere (as well as generally not being as greedy as a matter of corporate POLICY… new examples must be set.)

    I’ve received some great feedback from someone indirectly via this blog and so say thank you. (I will happily name him but not w/o his permission…

    That it might help me gain some support from investors…

    (I’ve had little luck with the two political parties who seem quite happy with the status quo at least at the organizational level… nor so far with VC’s who I now understand run from anything to do with politics)

    to point out that the system actually can significantly reduce middleman transaction costs…

    (which, of course was the whole idea)

    For ALL transactions!

    And in that sense, while having a kinship with x-box points or Facebook credits…

    As an enterprise its actually more akin to PayPal… except with added essential (patented) capabilities and a competitive advantage because of lower costs.

    I believe a for-profit, Commons-owned Internet pay system is a vitally needed institution…

    As for going to the time, trouble and expense of tying to legally protect something for the Commons… You’re welcome.

    In truth… and there is considerable truth in it… this is all just arose because I was trying to figure out how to make a living…

    I mean Ayn Rand wasn’t wrong about everything.

    Ayn Rand & Alan Greenspan: The Altruism Fly in the Objectivist Ointment

    Political Fundraising: Act Blue, Facebook and the Missing Network Imperative

    I now know there’s a lot more money to be made in highly complex financial innovation. But I’m just not smart enough for that so do what I can with the simple stuff.

    BTW, I’ve tried to post about this to Mr. Bookstaber’s blog but they’ve not been posted. Thanks for allowing ideas some air here.

  8. vlade

    Sometimes I do wonder though how much of this is self-inflicted. We, as a society seem to be much more risk averse and want others to move that risk away from us.

    The problem as I see it is that to be seen to remove those risks, we create more complex, rather than simpler system – to an extent exactly because complex systems are better at hiding risk (not removing risk – usually they transform it into a different sort of risk).

    Compare Dodd (few hundreds of pages IIRC) with Glass-Steagall (36 pages IIRC), yet Dodd doesn’t solve much and if anything provides a false sense of security to the unwary.

  9. Brian

    If anyone is interested the work referred to in Book staber’s post, Col Boyd’s “The Strategic Game of ? and ?” can be found here:

    http://www.ausairpower.net/JRB/strategy.pdf

    Boyd was a brilliant man who wrote the book on modern fighter dogfighting, was instrumental in a number of military aviation procurement processes (primarily the A-10 Warthog) and whose theories were used wholesale by the current US Marine Corp as battle doctrine.

    His biography is also a great read about an iconoclastic maverick taking on an entrenched system.

    http://www.amazon.com/Boyd-Fighter-Pilot-Who-Changed/dp/0316796883/ref=sr_1_1?ie=UTF8&qid=1301314890&sr=8-1

    1. Mark P.

      Yeah, John Boyd is a fascinating figure.

      I think historians a hundred years’ hence — if there are any — will still be assessing Boyd.

    2. DownSouth

      Yea! These Great Santini types are really the types we need running our nation’s banks, schools, businesses and government.

      From John R. Boyd’s “The Strategic Game of ? and ?”

      Human Nature

      Goal

      • Survive, survive on own terms, or improve our capacity for independent action.

      The competition for limited
      Resources to satisfy these
      Desires may force one to:

      • Diminish adversary’s capacity for independent action, or deny him the opportunity to survive on his terms, or make it impossible for him to survive at all.

  10. Tom Crowl

    (messed up html was driving my aesthetic sensibilities crazy so had to clean it up and try again)

    I’ve been thinking about these things for a while. Over two years ago I wrote the following as part of laying out the rationale for what I believe is a needed SIMPLE financial innovation.

    Civilization, Complexity & Collapse – The Search for Levers

    While one would hope that it would be the role of governments to protect both the Commons as well as the rights of the individual, there seems to be considerable problem accomplishing that.

    Part of the reason for that is an imbalance in the forces impinging on the decisions governments make… (there’s never a perfect balance nor a perfectly wise constituency; however our problem here is unaddressed systemic imbalances which become self-reinforcing with no mechanisms for correction…

    So an additional reason is the lack of any powerful institutional structures with both the will and the capability to check those influences.

    I also believe there are problems with banking and would like to see some more broadly-held structure capable of competing for some of those functions.

    Hence the concept of the Commons-dedicated Account under some sort of universal ownership… The viability for such a concept centers around reducing transaction costs in particular areas to facilitate needed activity in those areas (e.g. networked citizen lobbying via a viable micro-transaction) by achieving monetization elsewhere (as well as generally not being as greedy as a matter of corporate POLICY… new examples must be set.)

    I’ve received some great feedback from someone indirectly via this blog and so say thank you. (I will happily name him but not w/o his permission…

    That it might help me gain some support from investors…

    (I’ve had little luck with the two political parties who seem quite happy with the status quo at least at the organizational level… nor so far with VC’s who I now understand run from anything to do with politics)

    to point out that the system actually can significantly reduce middleman transaction costs… (which, of course was the whole idea)… For ALL transactions!

    And in that sense, while having a kinship with x-box points or Facebook credits… as an enterprise it’s actually more akin to PayPal… except with added essential (patented) capabilities and a competitive advantage because of lower costs.

    A for-profit, Commons-owned Internet pay system is a vitally needed institution providing synergistic benefits that go well beyond those that may seem most obvious.

    As for going to the time, trouble and expense of tying to legally protect something for the Commons… You’re welcome.

    In truth… and there is considerable truth in it… this is all just arose because I was trying to figure out how to make a living…

    I mean Ayn Rand wasn’t wrong about everything.

    Ayn Rand & Alan Greenspan: The Altruism Fly in the Objectivist Ointment

    Political Fundraising: Act Blue, Facebook and the Missing Network Imperative>/a>

    I now know there’s a lot more money to be made in highly complex financial innovation. But I’m just not smart enough for that so do what I can with the simple stuff.

    BTW, I’ve tried to post about this to Mr. Bookstaber’s blog but they’ve not been posted. Thanks for allowing ideas some air here.

  11. David G Wilson

    Yves: A superbly insightful piece encapsulating (albeit mainly in Bookstaber’s own words) the nature of complexity and its impact upon FS.

    The point re opacity is very well made! As you will see in this article (http://wp.me/p16h8c-im) opacity is “man-made complexity” and has a similar effect upon the the effectiveness of the multiple links and hubs within a non-linear business system as does the harmful LDL or “Bad cholesterol” (found in processed foods) upon the human system. Whilst key functions appear normal irreparable damage is being done. Apparently healthy systems can/do fail
    and are found wanting when the ecosystem within which it exists demands a level of performance for which it is no longer equipped.

    What was Machiavelli talking about? http://wp.me/p16h8c-s5

    It is imperative that people gain an understanding of Complexity and, wider systems-thinking, to enable them to see through the Financial & Political opacity that is created to mask the truth.
    THANKS

    David

  12. moslof

    The fact that households hold more stocks when valuations are at historically high levels supports this view. As far as mental health patients, the cyclothymic personality seems to be the best for modeling the economy.

  13. Francois T

    This is arguably true but is actually far too kind to financial firms. “Competitive advantage” implies that they need to offer newer, better, fancier gizmos just as cell phone makers have sought to meet or better yet leapfrog the iPhone. But “better” in terms of market share and appeal to customer, would in many cases imply simpler rather than more complex.

    Indeed! Complexity should be considered an offspring of deception until proven otherwise.

    The conclusion from this article from the New Scientist, 23 March 2011 – http://is.gd/w0MhNk is rather blunt:

    So don’t get too excited about the prospects for clever schemes to eliminate cheating just by tweaking the incentives. It’s not going to work. Not when the strategies used by bankers and hedge fund managers remain known only to themselves. There is, Young and Foster suggest, only one way to solve the problem: total openness.

    If I am an investor, and I can see for myself that the manager I have hired is only getting big returns by taking on excess risks, I am not likely to be fooled. To get this level of openness we would need new laws requiring much greater transparency from financial managers to their investors.

    Those playing the system will no doubt scream about laws eroding their ability to compete. But there is no getting around the logic that secrecy creates the opportunity for deception, and that no amount of clever tuning of incentives can prevent it.

  14. Middle Seaman

    The role of simplicity in any artificial human construction or process cannot be overstated. Naturally, outlawing derivatives will makes banks simpler and, therefore, more predictable and more manageable.

    Simplicity is the most powerful tool at our disposal to make artificial constructs and processes understandable, predictable and manageable. I have been researching computational models in large organization (human or otherwise) for many years. The most striking observation is that mishandling of organizational process is usually due to the failure to understand the dynamics and statics of the organization.

    Whether we can simplify the financial system is, mainly, a political question. With the current players, i.e. Obama, the GOP and the inflow of money from the financial system to politics, we don’t have a prayer.

    1. readerOfTeaLeaves

      Remove the complexity and transparency, and the big banks lose their profit. A bad scenario for hedge funds, no doubt.

      From Bookstaber’s post:

      The interaction between the market participants, and for that matter between the market participants and the regulators, is not a game, but a war. Complexity in the information battlefield, the willful creation of complexity – complexity that is peculiarly human in origin – and the resulting endogenous uncertainty, is particularly confounding for the neoclassicists. The battle spells trouble for the foolhardy armed only with the neoclassical methods.

      The good news, in my view, is that Bookstaber is continuing to dissect the same sinister economic assumptions that Yves eviscerates in Econned.

      More sunlight shining on that vampire called neoclassical economics, and its inability to grasp the implications of complexity, please!

      In making their case to Congress, the hedge funds, the banks, the commodities racketeers and assorted other traders rely on the neoclassical model. But in the information war called ‘markets’, that is sheer neoclassical gullibility — via the failure to grasp the contextual nature of complexity — and makes us sitting ducks for predation.

      That won’t prevent the financial interests from whining to Congress, but it does point to the fact that the more they whine and get their way, the bigger the next crisis will be. Because their neoclassical model becomes more outdated by the day, as complexity continues to increase exponentially.

      And as that complexity increases, so do the demands for contextual filters.
      None of which Congress appears to understand.

  15. Not the Real Bernie Ecclestone

    Please ease off on Formula 1 cars. They are designed to last the whole season, or as long as the rules defining the construction of the cars stay constant. They are designed to crash at enormous speeds without seriously injuring their drivers. Engine speeds are limited, and teams are only allowed to replace engines and transmissions at a defined rate throughout the season, unless they wish to suffer the penalty of being pushed down the starting line. Reliability and safety are keys to winning. The car and driver combination that least abuses either the car or the tires will tend to win because they don’t break. Pit lane speeds are tightly constrained, and fire is defended against with extreme effort. Fans are protected behind concrete walls, high fences, and runoff areas let cars slow down over time if there is a mistake or crash. The sport makes gobs of money all over the world. The sport and its business model are as complex as you can stand.

    What is wrong with bankers and the bureaucrats who enable them?

    1. Yves Smith Post author

      It’s not the same Formula One car if you replace the engine and other parts. The engine is the most important part of the car. You’ve proven my point.

      1. Attitude_Check

        So if you replace a door of your house, is it no longer your house? If you get a hip replacement, are you a different person?

    2. ScottS

      The F1 and cheetah analogy are both very good for explaining brittleness. F1 cars are very narrowly optimized. If a F1 car isn’t driving at 200mph, then the engine isn’t sufficient cooled, the specially-optimized brake pads aren’t warm enough to bite, the special compound tires aren’t warm enough to grip, slowing for turns gives you LESS grip because the aerodynamics are necessary to give the downforce necessary for grip. An F1 car doesn’t even have an internal starter motor or battery.

      At the end of the race, the engine is entirely rebuilt, and the suspension and aero pieces must be tuned for each particular track before the start of each race.

      An F1 car is good at what it does, but nothing else — it’s brittle, not robust.

      However, I don’t know if being brittle or specialized makes it “complex” in the context of this topic.

      I don’t know if complexity is the right aspect to attack the financial system on. I think the key word Bookstabber and Yves are looking for is robustness. Robustness leads me to my favorite (apocryphal) story:

      When westerners came to China to do business, the Chinese were very suspicious that the westerners drew up contracts to get in writing the terms of their agreements. The Chinese (rightly) viewed the contract as a way of hiding gotchas. They felt that business deals should be more like long-term relationships which would be mutually beneficial.

      The point is that business relationships that are a kind of personal relationship will profit both parties more in the long run than a gotcha-full contract. The key difference being that a relationship is more robust than a contract. There is room for give and take in a relationship, where a contract is rigid and unambiguous. Westerners are uncomfortable with such a cozy business relationship because it reeks of corruption.

      I personally would like to see something in the middle of the continuum where reputation is valued and maintained. MBAs have been selling off their companies’ name-equity, with precious little left. Now it’s time to kick out the MBAs and let the artists, entrepreneurs, academics, and engineers do the heavy lifting of putting equity back into companies’ names by delivering things people actually need, instead of silly financial “innovation” (read: obfuscation).

      Long-term greedy > short-term greedy

  16. Mary

    “But it is pretty clear that the officialdom has decided the time for action has past (except in the UK, where an epic battle is underway, much to the consternation of banksters).”

    It could be, the time for action resurrected itself when Treasure Islands came out (by Nicholas Shaxon), and the wider implications of the game became much more apparent. As it is now available in the U.S., perhaps some action will be reconstituted.

  17. Mbuna

    “We can only hope in the wake of the next crisis (because crisis is the inevitable result of the current model) that the nation’s leaders have the will to leash and collar the banks.”

    Hmmm, it seems to me that banks already have control over the nation’s leaders and that there are no current leaders nor any prospective possible future leaders that have or will have the will to confront the banks. So forget the hope because it’s not going to happen. When the next crisis comes I have no clue what the governments response will be except that whatever that response is, it will only favor the banks.

    1. lambert strether

      Mbuna, I think downsouth’s comment is on the money:

      Probably even more devastating to the sort of competition and pitched battle that Bookstaber relishes is the method of nonviolence.

      Watch the parking meters…

  18. David G Wilson

    @readerOfTeaLeaves: Complexity is a function of complex or dynamic (non-linear) systems – that underpins the functionality – so cannot be removed without impairing functionality. “Man-made” complexity – in the form of opacity – IS a very different matter!

    David

  19. A H

    Great post, but I have one quibble,

    “They need to be operated like utilities, with extensive regulation and oversight, and excess profits should be seen as probable evidence of rule breaking and investigated. You don’t want a terribly efficient financial system; highly efficient systems are prone to breakdown.”

    Regulated utilities are often more efficient than private firms because they can take advantage of economies of scale and marginal cost pricing. Private firms will place prices were profit is highest which is inefficient. High profits in general are usually a sign of inefficiency.

    Of course mainstream economists only seem to care about inefficiency as it relates to the labor market..

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