Friday, March 22, 2013

"To Understand Finance, Embrace Complexity"

From Bloomberg:
A highly unusual collaboration between economists and scientists offers an important insight for those who want to fix the world’s crisis-prone financial system: There’s no simple way to understand a complex network.

This month’s issue of the research journal Nature Physics features a handful of papers in which physicists, other natural scientists and leading experts in economics and finance -- including prominent banking regulators and Nobel Prize-winning economist Joseph Stiglitz -- put their minds together to figure out finance. What the scientists bring to the table is experience in studying networks, bewildering tangles of interlinked and interdependent things such as an ecological food web or the Internet. 

Take a look at any diagram showing the interconnections among the world’s banks and other financial institutions -- links established through ordinary loans, but far more extensively through financial derivatives -- and what you see will be very complex. We barely understand how such complexity changes the way networks operate. What we do know suggests we should worry when there’s too much of it.

Fifty years ago, ecologists interested in the stability of food webs at first mistakenly concluded that more complexity -- more species and a greater density of links among them -- would tend to make an ecosystem more stable. This turned out to be wrong. Later work by noted ecologist Robert May demonstrated that while healthy ecological networks are rich and diverse, too much complexity tends to make them unstable and prone to collapse. Loosely speaking, networks with too much complexity can go wrong in too many ways.
Explosive Complexity
Sound familiar? The complexity of the financial system exploded over the past few decades, primarily through the proliferation of derivatives of all kinds. Then the system itself blew up. What the papers in Nature Physics argue is that any really deep understanding must focus on the detailed pattern of links among institutions, or the network “topology.” (Full disclosure: I write a monthly column for Nature Physics.)....MORE
We last touched on complexity in Wednesday's "The Joy of Randomness: Central Bank Strategy, Management Technique and Stock Selection":
...Ya see, ya got your complex systems and ya got your chaotic systems and then ya got your complex-chaotic systems like weather or the economy or the stock market and when you endeavor at those levels of sophistication you realize:
"Nobody knows anything"
-William Goldman 
Complex systems are not to be confused with "the Caulk/Putty/Grout Complex" which was a post on trading the energy-efficiency aspects of the stimulus and is, actually, a different meaning of the word "complex".
And yes, contrary to the quote above, some people do know something, it's just that it is damn hard making money off it. 
See also Sept. 2012's: