Thursday, October 23, 2014
Thursday, October 16, 2014
As is obvious by looking at the time span between recent posts, I have not been active in blogging. I am planning to get back into things. As a start, to help catch up on what I have been doing, here are a couple of papers and a presentation I recently made on the area of my focus, using agent-based modeling to help assess financial vulnerabilities.
The model is presented here.
For a concise presentation on the model and its application you can look at a talk I did in August at the Newton Institute for Mathematical Sciences at Cambridge University. (Despite what is suggested by the venue, I did the presentation mathlessly).
Related to the model is work I have been doing to develop a map of sorts for the key agents in the financial system and the ways in which they link to one another. The fist step is what I call the funding map.
Wednesday, May 7, 2014
Tuesday, March 18, 2014
Wednesday, November 20, 2013
Sunday, March 3, 2013
In the first paragraph of my book A Demon of Our Own Design (Wiley, 2007) I observe that “You don't deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book – it is going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.” I then spend a significant portion of the book explaining the mechanics that lead the financial markets to lurch from crisis to crisis; why is it that while engineering in other fields increases safety, financial engineering seems to make things get worse. I suggest that the problem stems from the complexity and tight coupling that we introduce into the markets; complexity through financial innovations, tight coupling through leverage.
A system that is both complex and tightly coupled will almost inevitably have occasional accidents, what engineers term “normal accidents.” Attempts to reduce these accidents by adding in safety measures might actually increase their frequency because the safety measures add further complexity. This is not merely a philosophical point; in my book I go into detail on how some notable accidents – Chernobyl, Three Mile Island and Value Jet – occurred because of the added complexity from safety measures.
We can delve more deeply into the question, because even if we accept the argument from normal accidents, it still seems that financial markets have more than their fair share. Crises seem integral in financial sphere in a way that they do not in other industries. So we can pose the question of what it is about financial markets and the financial industry that make them different. There is an obvious and at the same time deep answer, one that relates to the essence of social interaction.
Lender or Borrower Be
“To breed an animal with the right to make promises—is not this the paradoxical task that nature has set itself in the case of man?” – Nietzsche
In the Stanford “Marshmallow Test”, a child is placed in a room alone with a marshmallow and told that he may eat the marshmallow now, but if he waits ten minutes without eating it he will get two marshmallows. The punchline for the test is that there appears to be a relationship between the ability to wait and success later in life. (Not considered is how much the child actually likes marshmallows – I imagine an astute child who hates marshmallows eating the one immediately so as not to face eating two later. Neither is considered how much the subject ate for lunch before the test).
This is a test of an innately human trait: the willingness to sacrifice today for a later reward. For Toynbee, this trait is the mark of civilization, because it is only through building structures, clearing land, planting trees, all designed to find function beyond one's own life, that civilization can take root. When this trait occurs between two parties, we have created the relationship of the creditor and debtor. For Nietzsche, the promise enacted between creditor and debtor is the source of conscience and mercy. And, ultimately it is also the source of feudal classes and of what we now call capitalism.
The human trait of binding oneself now to gain a reward in the future leads to our ability to make promises. And the ability to make promises leads to three other traits: First, a conscience. And, because conscience only goes so far, the right to mete out punishment for non-performance. It also requires that people be similar, or at least predictable, because unlike a trade in the present, a promise is an abstraction that requires both parties share the same context.
It is through the creditor/debtor relationship that the rudimentary concepts of economic exchange – setting prices, determining values, agreeing on equivalences – evolved to introduce concepts of rights, contract, obligation, and means of settlement into society. With regard to the ability to enforce the terms and to punish those who fail, it also introduced the concepts of measuring one's power against another. And the promise required yet other characteristics we find essential to civilization: the ability to reach and record an abstract understanding, and to trust.
Nietzsche takes this beyond the corporeal to the extreme of the spiritual, where the realization of the promise is not in one's lifetime. The creditor becomes Christ, salvation to the debtor in the future for obedience and faith in the present. Nietzsche states, “we stand before the paradoxical and horrifying expedient that afforded temporary relief for tormented humanity, that stroke of genius on the part of Christianity: God himself sacrifices himself for the guilt of mankind, God himself makes payment to himself."
The Abstraction of Promises
It is the role of creditor and debtor that differentiates finance from economics. The most common and primitive economic act, that of trading goods, whether in kind or through a medium of exchange, does not have an temporal separation and does not invoke a promise. The promise and its traits come about once the roles of creditor and debtor become part of society, that is, once a financial exchange occurs.
In measured steps, finance has added layers of abstraction to the creditor/debtor relationship. In early society promises were made in kind. One good was delivered in exchange for the promise of another. Then collateral was attached to the loan – if the item being loaned formed the collateral, it was the equivalent of modern-day mortgage bonds. Collateral also could take the form of an agreement to be punished in the face of non-performance; the preverbal pound of flesh. With the advent of money came the promise made in terms of a payment that required a notion of equivalence, a general obligation bond. As with any promise there was the risk of default, but otherwise the payment made and received was fully defined in monetary terms. This made debts more easily transferable, creating what was essentially a bearer bond rather than an obligation to a specific creditor.
With the advent of mercantile trade in Medieval Europe came capital for financing the fleet and crew in exchange for the promise of a share of the bounty. This is the critical step in differentiating promises in finance from those in other areas, because the promise was defined in terms of unknown value. The final step in the chain of increasing abstraction and uncertainty came with forward contracts, where both the roles of the creditor and debtor were blurred. Both parties owed and were paid, but the exchange occurred in the future. One or the other part of the exchange was of uncertain value – indeed it did not yet exist – and funds could be more easily borrowed if the uncertain value was converted to a certain one.
Promises, Punishment and Mercy
In a primitive society, the punishment for reneging on a promise could be severe. This was because the “shadow of the future” was short, and because the debtor might not be brought to punishment. But as the structure of society progressed, punishment became more certain. People formed societies where reputation was critical, and as the societies became more stable, the failures of the debtor could be absorbed more easily. As people became more wealthy and their status secure – and those with wealth were the likely creditors – they could afford to reduce the severity of punishment. One path of this social evolution led to the feudal relationship of lord and vassal: the beneficent creditor and the loyal debtor. This process came to the point of contributing to a societal role for forgiveness and mercy. Nietzsche observes that:
Note: This post draws heavily from Nietzsche: On The Genealogy of Morals, from which the quotes are taken.