Friday, October 19, 2007

Complexity and Non-Linear Consequences

The Tower of Babel. Easter Island. Kurt Godel and Werner Heisenberg. A nuclear reactor. Innovative Finance. Rube Goldberg. Bread crumbs.

If the connections between the above references are not quite clear, allow me to explain.

The tower of Babel is one of mankind's oldest warnings about the destructive forces unleashed when complexity takes over. Interestingly, complexity was God's punishment. Think about that for a second: complexity as punishment! There is a lot of wisdom in The Bible.

Easter Islanders built a highly complex societal system for the purpose of constructing, transporting and erecting the famous moai statues dotting the shores of their island. They became so absorbed in this activity, that they eventually stripped the land of all resources and imploded.

Kurt Godel was the mathematical genius who proved that there are theories that can never be proven. Heisenberg took that idea one step further into the physical world with his Uncertainty Principle. In other words, there are things we do not know and which we will never know.

Pause: complexity is a necessary element in any social system. The question is, how much complexity is beneficial? How far do we go without eventually producing a tower of Babel? If we go too far in creating complex systems we reach a point where minute variations quickly result in disproportionate effects, like the butterfly in China creating a storm. Enter Godel and Heisenberg: we know that we will have unexpected variations, because we cannot know and control everything a priori.

Furthermore, the results may be catastrophically non-linear. The nuclear reactor is a perfect example: a small increase in the number of neutrons leads to an uncontrolled chain reaction. Another example is a chemical reaction that proceeds very slowly on its own until we introduce a catalyst, at which point it will run away and cause an explosion. Highly complex systems are prone to non-linear behavior; and the more complex they become, the higher the probability of critical, non-linear events.

Second pause: with "innovative" finance we have constructed the equivalent of a series of global financial nuclear bombs. We have sliced and diced every conceivable stream of income and variation from "norm" and re-packaged them into new "products". In previous posts I showed how a simple mortgage spawns third and fourth derivative products like CMOs, CDOs, CDSs, hubrid CDSs and CPDOs, each of them a step up in complexity and price volatility from the one before, all linked together in a tight relationship. The same has happened with equities, insurance receivables, energy, shipping... you name it, our financial engineers have taken it apart and put it back together like so many Lego blocks.

It looks to me that, after a point, all we have accomplished with "innovative" finance is the construction of a number of Rube Goldberg contraptions that end up doing very simple tasks through a series of inter-connected complicated and convoluted steps, each prone to its own risk of failure. Each individual risk may be small, but added together they can propagate toward total collapse. The risk is now in the system itself, not in the exogenous events.

Why have we done this? Because at each step there is "friction", aka fees and commissions. Crumbs, as Sherman McCoy from Bonfire of The Vanities would put it. But Tom Wolfe wrote his epic at a more innocent time, even though it was only 20 years ago. Today we are no longer content with the few crumbs that remain on the table. Instead, we as investment bankers, traders and speculators, grate entire loaves into bread crumbs, take out as many as we possibly can for ourselves and then put them back together for sale as bread sticks.

18 comments:

Miju said...

is non linear progression catastrophic ? you examples give a "yes" answer. But progress (scientific or social) is never linear...revolution...the question is about to avoid the "progress" bomb that will kill the evolution process. Looking backwards, finance has created a lot of nuclear bombs since 20 years but the world is richer today and never poor countries have accessed to their strong power nowadays in such a short period of time. this is about life !

Anonymous said...

Indeed, there is a lot humans will never know. The bible is just another example of hubris masquerading as a key to understanding the universe. Anyone advocating further "progress" without considering the ecological impact of 6.5 billion people all craving conspicuous consumption is a fool. The "world" is in no way "richer" today when compared with twenty years ago. There's more people in poverty, more petroleum depleted that's not coming back, less biodiversity (by far), less fresh water, the ice caps are melting, I mean, how much more proof does one need before recognizing we've got a serious problem? This isn't about "life", it's about your bank account.

Anonymous said...

Hellasious,

That commentary was brilliant. I loved it. Truly thinking outside of the box.

Bernard

David said...

Are you, like, a polymath or something?

Anonymous said...

Niklas Luhmann's systems theory adds a great deal to the theme of complexity. He recognized that subsystems such as the state (administration, bureacracy) and the economy (markets) functioned as semi-autonomous systems. These subsystems overwhelm societal forms in which stuctures of intersubjectivity collapse and individuals are disengaged from their lifewords. In highly complex societies said subsytems must function in a semi-autonomous fashion to allow for coordination in increasingly compex environments.

Jurgen Habermas extended upon Luhmann's thinking to recognize that under the conditions described above social reproduction, integration and socialization become anemic - in which cultural forms increasingly dissolve, removing the very social foundations on which economic and political systems function, engendering a feedback loop of internal collapse.

Anonymous said...

To add to the discussion of Luhmann and Habermas, we can see similarities in the relaltionship where finance (in which highly complex financial engineering generates credit/debt) drives the real economy. But tables are reversed when the effects of finance on the real economy turn around - in which housing/subprime poisons finance. So, could it now be that we're back to where the real economy drives finance, in which a feedback loop speeds the decline of the real economy only to speed the decline of finance (lending diminishes substantially), which in turn creates more pressure on the real economy.

Juan said...

Anon,

Habermas was interesting but to extent he took production of culture to be determinant he also failed to grasp the capital system's grounding in its particular social relations of production and the contradictions within these as well as between them and the political, economic, cultural forces they generate, forces which finding their limits within the relations seek to burst through even as they attack one another.

In short, the cultural did not give birth to itself but is an outgrowth which reacts back upon that from which it originates and plays a part in society's REproduction of itself,,,which can never be balanced, other than in neoclassical fantasies, never be in general equilibrium.

We are talking about analytic method which is both theory and philosophy of internal relations, 'dance of the dialectics', and of exogeneity which isn't but merely appears to be.

Edwardo said...

To anonymous, the second poster to comment, I say, AMEN!

Complexity is breaking down and then some. That game is over folks. Get ready to batten down the hatches. The Greater Depression, i.e. a massive cessastion of complexity, is on the way.

And everything that has gone up in the paper shares realm since the lows of August has been, merely papering over the ugly reality that insolvency is rampant and beyond redress. Liquidity, as old Hellasious has pointed out, is no solution to the crumbling of our complex system.

So don't be fooled by all the bouncing around that will occur between now and Thanksgiving. A year from now the vaunted markets will be in tatters.

OkieLawyer said...

I have read that societies advance through specialization. Basically, this means that individuals within those societies become experts in very narrow skill sets. By their nature, those societies are very complex.

As in the Babel story, language becomes a natural barrier to the advancement of human knowledge (natural disasters can be another). As those barriers break down, more knowledge can be deduced as to complex scientific and mathematical truths.

As those mathematical models relate to financial instruments, the real problem is not with the knowledge of complex financial models, but with the prevention of the ill use of that knowledge.

There is a famous saying among accountants and attorneys: "All great wealth starts with a crime." The reality is that many of the most successful people in business are often sociopaths. Financial (white collar) crimes are notoriously difficult to prosecute precisely because of their complexity. Even where prosecutions are successful, many times the victims have no adequate remedies. The money that has been scammed from them has been destroyed or hidden so successfully that recovery is virtually impossible.

It is for this reason that strong regulations must be put in place proactively to prevent fraud from happening and reactively to make such activities unprofitable for the scammer.

But we seem to be going in the opposite direction on that front.

Edwardo said...

okielawyer wrote,

"The reality is that many of the most successful people in business are often sociopaths."

Too true. And to the extent that the better part of our culture is devoted to the pursuit of outsized financial gain, can it likewise be said that our culture is, in large part, sociopathic? I imagine many would shrink from that assessment. How could we here in "freedoms land" possibly fit such a profile? Well, when you elect one epic grifter after another to the highest elected office in the land how could one think otherwise?

If one is willing to accept the unpalatable idea that the criminals don't just inhabit the prison, but run it, then one can better understand why the following excellent idea:

"...strong regulations must be put in place proactively to prevent fraud from happening and reactively to make such activities unprofitable for the scammer."

can never happen until such time as it makes but scant, if any, difference. Such is life in the U.S.

Brian P Woods said...

Complexity cascading to disaster is aka., A Normal Accident: Charles Perrow; 1984 and 1999: ISBN (10) 0691004129.

Anonymous said...

"The reality is that many of the most unsuccessful people in business are often sociopaths."

"The reality is that many of the people outside business are often sociopaths."

Anonymous said...

"Kurt Godel was the mathematical genius who proved that there are theories that can never be proven. Heisenberg took that idea one step further into the physical world with his Uncertainty Principle. In other words, there are things we do not know and which we will never know."

Brilliant post. However, I would change "that can never be proven" to, that our minds are not advanced enough to prove. As you can see I'm an optomist. Einstein's theory of relativity opened many doors for us.

"God created the animals for their inocence, the plants for their simplicity and man to confound him. Boy, he must be very amused right now..." (or something like that).

Thomas Bolt - A Man for All Seasons

Let's just have some fun..... ;-)

Econolicious

Independent Accountant said...

I have said things like this ever since 1980. Now I know I am not alone in my thinking.

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