Financial Crisis Observatory

In a recent NZZ article [1], Rolf Dobelli, co-founder and chairman of getAbstract and organizer of zurich.minds, claims that society has never been more complex, and that this complexity has reached unmanageable levels. In his view, experts just pretend to have an understanding that they do not have. He concludes that never before the science of economics has failed more spectacularly.

I disagree with his view. For several reasons.

1) As masterly studied by  Rogoff and Reinhart [2],  economic and banking crises are the norm rather than the exception… for the last 8 centuries! And they proceed according to reproducible scenarios, based on fear and greed, and the development of a tipping point when markets lose confidence in the government’s ability to pay, and the game stops. Thus, while large in amplitude and spread, the present time is not fundamentally different from many previous events described by Rogoff and Reinhart [2].

2) Crises allow us to learn. Human beings and societies mainly learn at times of stress. But they also forget… and repel previous regulations (such as the Glass-Stegall Act, which was designed in the 1930s to control speculation by banks) put in place to prevent financial instabilities to occur again, on the false but attractive premise that things have changed, that we are better, more clever, more innovative, with better risk management instruments. The problem might not be the complexity, only the hubris that we have changed and this is a “new economy”.

3) Modern city-dweller humans tend to consider their cities and their societies as much more complex to handle that the supposedly more primitive environment of our ancestors hunter-gatherers. I would call this a specialist blindness.

As modern men and women, being specialized to deal with modern traffic, TVs, computers and virtual worlds, we have become basically blind to the thousands of weak signals that a “primitive” hunter-gatherer has learned to read off the book of nature, deciphering the different hundred of plants, the delicate differences between footprints of tens of animals, the myriad of fruits and insects eligible for food, and so on.

4) Complex systems, such as our societies, cannot be known. They are utterly unpredictable. This is true… at some level but not at all levels.

Consider the most formidable of algorithmic information theory, which combines information theory, computer science and meta-mathematic logic. In the context of system predictability, it has profound implications. Indeed, a central result of algorithmic information theory obtained as a synthesis of the efforts of R. Solomonoff, A. Kolmogorov, G. Chaitin, P. Martin-Lof, M. Burgin and others states roughly that “most” dynamical systems evolve according to and/or produce outputs that are utterly unpredictable. Here, the term “most” in “most dynamical systems” mean that this property holds with probability 1 when choosing at random a dynamical system from the space of all possible dynamical systems. Specifically, the data series produced by most dynamical systems have been proved to be computationally irreducible, i.e. the only way to decide about their evolution is to actually let them evolve in time. There is no way you can compress their dynamics and the resulting information into generation rules or algorithms that are shorter than the output itself. Then, the only strategy is to let the system evolve and reveal its complexity, without any hope of predicting or characterizing in advance its properties. The future time evolution of most complex systems thus appears inherently unpredictable. This is the foundation for the approach pioneered by S. Wolfram (the founder of Mathematica) to basically renounce the hope to get mathematical laws and predictability, and replace them by the search for cellular automata that have universal computational abilities (like so-called Turing machines) and can reproduce (but not diagnose or predict)  any desired pattern.

However, this exact theorem is fundamentally misleading. The key is to ask only for approximate answers at some level of coarse-graining, which for instance makes physics work, unhampered by computational irreducibility. By adopting the appropriate “coarse-grained” perspective of how to study the system, one can show that even the known computational irreducible cellular automaton (rule 110 in Wolfram’s classification) becomes relatively simple and predictable.

In summary, I claim that complex systems such as those created by humans are no more and no less understandable than before. One just needs the right concept, level of perspective and coarse-graining, and the corresponding tools. Some scientists have come to realize this and progress is on-going at a fast pace, with many new initiatives, in particular at ETH Zurich.

The implications for policy is that the coarse-graining approach provides a way to balance between the microscopic forces that drive human beings (such as fear, greed and love) and the macroscopic level of organization. The latter can be made more resilient by suitable design and careful regulations, with careful account for their unintended feedbacks and consequences.

[1] Rolf Dobelli, “Im Wunderland – Wir haben eine kognitive Grenze ueberschritten”

[2] C.M. Reinhart and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press (2009)

Greece is one of the EU member countries that faces the most severe problems. Only a few years ago, the story looked different. The Greek economy was one of the fastest growing in the eurozone. It grew at an average annual rate of 4.2% from 2000 to 2007.

During this time, the government of Greece ran large deficits. The now common perception of Greece problems developed with the luxury of hindsight is that they were caused by the reckless borrowing practices of its government. Greece went on to issue more and more government debt, which added up to an estimated deficit of 13.6% of GDP given by the Greek government in May 2010. This unsustainable regime has led to the turmoil in Europe, with the extraordinary measures taken by the ECB (European Central Bank) buying sovereign debts and by the European governments developing a bail-out contingent plan of up to 750 billion euros.

But was it entirely the fault of the Greece government?

Richard A. Werner, International Banking professor and author of several books about the Japanese crisis [1] takes a provocative view. He points out that the European Central Bank (ECB) has to be blamed at least in part for the Greece’s problems [2]. The ECB emphasizes that its focus is interest rate policy, which is identical across the eurozone. Unknown to the public however, the ECB encouraged the governments of countries like Greece, Ireland, Italy, Spain and Portugal (PIIGS) to engage in unrealistically high revenue growth projections before the upturn of the crisis [3]. This was conducted by boosting commercial bank credit growth, which was supposed to finance the high spending. In contrast, Germany’s credit creation had been restricted, which led to weak growth and rising unemployment. The ECB implemented regionally diverse credit growth policies, which led to booms and bust in the corresponding countries [4].

A paradigm shift

Werner’s insight is based on the idea that interest rates are not the determinants of economic growth – which is the view that mainstream economics share – but the amount of credit created by banks is the main factor predicting growth. He suggests that the mainstream view has been focusing on the wrong indicator (interest rates) in the recent decades. Werner suggests a paradigm shift – from an interest rate determined economy to a credit driven economy.

It is my deep conviction that financial crises do not emerge out of the blue. I claim that diagnostic methods and predictions of speculative bubbles can be made before their ends confirm their existence.

Until recently, the widespread general opinion both in academia, professional circles and in the public was that of disbelief, if not outright rejection. Policy makers were convinced that the current crisis could not have been foreseen and that recent crashes in markets were surprising events. But it seems now that a turning point is being reached and perception starts to change. Two top policy makers stated recently that financial crises might be the logical consequence of preceding events – and therefore predictable.

Jean-Claude Trichet, President of the European Central Bank (ECB) says in his speech on 27 April 2010 [1]: “First, I will argue that financial crises share some commonalities. In particular, crises are associated with the emergence of euphoria and complacency in financial markets, typically supported by rapid credit growth and a growing belief that new concepts like financial innovation or technological advances have rendered old limits on economic performance obsolete. The existence of such commonalities in the anatomy of financial crisis gives rise to a number of hopes. They suggest that it is possible to develop warnings of nascent crises at an early stage. They imply that policy-makers could design and implement policies that contain or avoid such crises.”

Later, he explains: ”Such commonalities offer hope that policy-makers can detect, at an early stage, a nascent financial crisis. On the basis of inductive logic, we can exploit historical regularities to help predict the future. Being able to identify financial tensions would allow appropriate policy actions to be taken in a timely manner.”

William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York) said in his speech “Asset Bubbles and the Implications for Central Bank Policy” [2] in early April 2010: ”Turning to the first issue of whether there are asset bubbles, I am going to be a bit of a heretic and argue that there is little doubt that asset bubbles exist and that they occur fairly frequently.”

And he continues: ”In conclusion, let me underscore the challenge that central bankers face in combating asset price bubbles. Doing so effectively requires us to be successful in both identifying the incipient bubble and in developing and implementing a response that will limit bubble growth and avert a destructive asset price crash. This is not easy because asset bubbles are hard to recognize in real time and each asset bubble is different. However, these challenges cannot be an excuse for inaction. Recent experience strongly suggests that asset bubbles exist and that their collapse can be very damaging to the financial system and the macroeconomy.”

Mr. Dudley and Mr. Trichet not only admit that asset bubbles do occur, but they even suggest that it might be possible to diagnose the growing instabilities and then take steps to contain or avoid such crises.

[1] Trichet, Jean-Claude, “What can central banks do in a financial crisis?”, April 27th, 2010

[2] Dudley, William C., Asset Bubbles and the Implications for Central Bank Policy”, April 07th, 2010

There is a tendency for society at large to assume unrealistic returns. This is definitely a trait that contributes to bubbles in stock markets. In fact, developed economies grow roughly on average at about by 2-3% per year above inflation. Thus the expectation that pension funds investments will pay 8% annually on average over the long term is unlikely (except if inflation sores and devaluates away the pension liabilities). The articles [1], [2] and [3] illustrate that pension funds are forced to play risky games in order to address their liabilities via asset appreciation targets.
This in turn puts more money in the financial investment machine, inflating prices and, in passing, justifying the exorbitant size of the finance industry. This adds to the pro-cyclical investment process, building the fuel for a global conflagration.

[1] Public Pension Funds Are Adding Risk to Raise Returns
http://www.nytimes.com/2010/03/09/business/09pension.html?pagewanted=1&hp&adxnnlx=1268140519-AX81Zegns8XyCOXTxuOwOA

[2] Gambling our future
If state pension obligations were discounted properly their unfunded liabilities would be more than three times the value of all outstanding municipal debt.
http://www.economist.com/blogs/freeexchange/2010/03/pension_crisis

[3] Trillion-Dollar Pension Crisis Looms Large Over America
http://www.iimagazine.com/Popups/PrintArticle.aspx?ArticleID=2442415

The financial sector has roughly doubled in relative importance (4% to 8% of GDP) since the Great Depression in the 1930s [1]. From its role as a servant of the real economy, it turned into a frightening powerful force overdoing its original purpose. Of course, excesses have been present at all times, but this has been somewhat forgotten during the illusion of the “great moderation” in the 1990s and until 2007.
Criticism of the enormous power of Wall Street is now abundant – Simon Johnson and others accuse Wall Street to abuse its power to make money at any cost without regards to negative externalities to the economy or to society [2]. Current suspicions of unethical and perhaps illegal behaviors are illustrated by the SEC charges against Goldman Sachs. The obvious tight connections between Wall Street and Washington provide insider information to the former, which can be assumed to be readily transformed into profits, driven by just the standard rationality of maximizing profits [2]. While this is very difficult to assess from available data, casual discussions with top financiers reveal that they often choose to trade on what they consider (rightly or wrongly) as private or even insider information. Wall Street has just institutionalized this process into a well-oiled and ever more  powerful money machine.

How to break this stalemate where an industry holds most of the cards?  History suggests that only catastrophes of extraordinary proportion can move societies to address at last their extraordinary problems.  It seems that our predicaments since 2007 are much too small to reach the threshold. As the crisis has been fought by leveraging even more debt, leveraging being the very instrument of the crisis itself, we should be confident that the catastrophic threshold for the welcome revolution will be reached quite soon, perhaps just a few more years.

[1] Has the Financial Sector Grown too big? The Paradigm Shift after the Crisis, by Lorenzo Bini Smaghi

[2] The Sickening Abuse of Power at the Heart of Wall Street, by Simon Johnson