Chaos On Wall Street

PBS' News Hour recently featured a Paul Solman interview of Benoit Mandelbrot, a mathemetician known for his work on Chaos Theory, and Nassim Nicholas Taleb, author of the book "The Black Swan: The Impact of the Highly Improbable." It offers unique insights into our current financial crisis, drawing from the perspectives of Chaos Theory and Complexity. Their joint message appears to be these are very disturbing and unsettling times - more than we even realize. (That's reassuring!) You can see it here.

Complexity on Wall Street

I'll be the first to admit I don't know much about economics. Then again, based on the last few weeks, there are a lot of people on Wall Street that don't know much about economics either. (Why would an investment house acquire assets it doesn't know the value of?)

Anyway, it's clear that there's going to be a lot of Monday morning quarterbacking of the whole financial system when things finally calm down. The following two articles - one in the New York Times and one in the Washington Post - offer intriguing views on some of the flaws in the current system, drawing on ideas from modern science.

In his Times article This Economy Does Not Compute, theoretical physicist Mark Buchanan takes issue with traditional economics' methodology. He begins by discussing the shortcomings of equilibrium theory, which "views markets as reflecting a balance of forces."

He argues:

Really understanding what’s going on means going beyond equilibrium thinking and getting some insight into the underlying ecology of beliefs and expectations, perceptions and misperceptions, that drive market swings.

Buchanan says a number of people are now using computer models to get this insight. After discussing three different models and their initial findings, he notes:

Sadly, the academic economics profession remains reluctant to embrace this new computational approach (and stubbornly wedded to the traditional equilibrium picture). This seems decidedly peculiar given that every other branch of science from physics to molecular biology has embraced computational modeling as an invaluable tool for gaining insight into complex systems of many interacting parts, where the links between causes and effect can be tortuously convoluted.

He concludes:

If we’re really going to avoid crises, we’re going to need something more imaginative, starting with a more open-minded attitude to how science can help us understand how markets really work. Done properly, computer simulation represents a kind of “telescope for the mind,” multiplying human powers of analysis and insight just as a telescope does our powers of vision. With simulations, we can discover relationships that the unaided human mind, or even the human mind aided with the best mathematical analysis, would never grasp.

Better market models alone will not prevent crises, but they may give regulators better ways for assessing market dynamics, and more important, techniques for detecting early signs of trouble. Economic tradition, of all things, shouldn’t be allowed to inhibit economic progress.

In a similar vein, James G. Rickards takes issue with the prevailing wisdom on risk management in his Post article A Mountain, Overlooked; How Risk Models Failed Wall St. and Washington. He begins by describing the way risk has been evaluated by financial institutions up to now, using complex mathematical models:

Since the 1990s, risk management on Wall Street has been dominated by a model called "value at risk" (VaR). VaR attributes risk factors to every security and aggregates these factors across an entire portfolio, identifying those risks that cancel out. What's left is "net" risk that is then considered in light of historical patterns. The model predicts with 99 percent probability that institutions cannot lose more than a certain amount of money. Institutions compare this "worst case" with their actual capital and, if the amount of capital is greater, sleep soundly at night. Regulators, knowing that the institutions used these models, also slept soundly. As long as capital was greater than the value at risk, institutions were considered sound -- and there was no need for hands-on regulation.

However, he notes "Lurking behind the models...was a colossal conceptual error: the belief that risk is randomly distributed and that each event has no bearing on the next event in a sequence." This is basically the same idea as tossing a coin: no matter how many times heads comes up, the odds of it being heads or tails the next time is still 50-50. But are markets really like coin tosses? Rickards says:

Both natural and man-made systems are full of the kind of complexity in which minute changes at the start result in divergent and unpredictable outcomes. These systems are sometimes referred to as "chaotic," but that's a misnomer; chaos theory permits an understanding of dynamic processes. Chaotic systems can be steered toward more regular behavior by affecting a small number of variables. But beyond chaos lies complexity that truly is unpredictable and cannot be modeled with even the most powerful computers. Capital markets are an example of such complex dynamic systems.

Think of a mountainside full of snow. A snowflake falls, an avalanche begins and a village is buried. What caused the catastrophe? The value-at-risk crowd focuses on each snowflake and resulting cause and effect. The complexity theorist studies the mountain. The arrangement of snow is a good example of a highly complex set of interdependent relationships; so complex it is impossible to model. If one snowflake did not set off the avalanche, the next one could, or the one after that. But it's not about the snowflakes; it's about the instability of the system. This is why ski patrols throw dynamite down the slopes each day before skiers arrive. They are "regulating" the system so that it does not become unstable.

Rickards concludes:

Financial systems overall have emergent properties that are not conspicuous in their individual components and that traditional risk management does not account for. When it comes to the markets, the aggregate risk is far greater than the sum of the individual risks; this is something that Long-Term Capital Management did not understand in the 1990s and that Wall Street seems not to comprehend now. As long as Wall Street and regulators keep using the wrong paradigm, there's no hope they will appreciate just how bad things can become. And the new paradigm of risk must be understood if we are to avoid lurching from one bank failure to the next.

I, for one, vote a Big No on all this lurching. Hopefully, Buchanan and Rickards can get their messages through to the Powers That Be.

What's Going On?

It's hard to look at what's happening in the world today without wondering what the heck is going on.

To take just the latest example...America's financial system appears to be spinning out of control, and nobody can agree on what caused the current problems or how we should deal with them. Any solution proposed is broadly met with skepticism because no one believes the government or the business community has either the ability or the integrity to develop a proper and workable solution. Meanwhile, as we're attempting to deal with this problem, its effects ripple out through the rest of the world's financial systems.

As we're dealing with all this, we're confronted with similar problems in many other areas: the environment is stressed, personal integrity and ethics seem to be irrelevant in today's society, and people of different cultures, tribes or religions seem to be at each other's throats.

When people view such problems, they seem to react in one of three ways: they deny there's a problem, they try to force their solutions on everyone/everything else around them, or they throw up their hands and say it's hopeless and nothing can be done.

As if that isn't enough, there appears to be a general abandonment of common sense. If we had looked rationally at the housing bubble, we would have had to admit it couldn't last forever. If we had looked rationally at the cultural dynamics of the Middle East, we would have realized invading Iraq was not likely to be a "piece of cake." And if we looked rationally at all the junk being dumped into the environment around the world, we would have to acknowledge that we've been gradually making our world uninhabitable.

What's going on?

And what are we to do?

I believe we are going through a period of great change. This change is a product of the many new technologies that have been made possible by modern science. These technologies, in turn, are rooted in the ways science has come to redefine our understanding of our world.

I believe that if we draw on principles discovered by modern science, we will be able to develop a new form of common sense - a "quantum sense," if you will - that can give us new ways of seeing our world and new approaches to solving its problems.

Today many people are doing exactly that - drawing on lessons from modern science to propose new solutions. As I come across examples of this, I'll present them here. I'll also comment on issues from time to time, drawing on what I call "eight facets of the quantum world." You can get a rundown on those facets, as well as my general ideas on this subject, at my web site "Quantum Age."

Meanwhile, I welcome any leads on other cases where someone has used ideas from modern science to develop a new approach to a seemingly intractable problem. And I hope you'll join me as we strive to achieve "quantum sense."

Thanks for stopping by!