Capitalism at a Cross Roads
Considerations of Persistent Disequilibria and Positive Feedback: Finding the Butterfly
PREFACE
The twin marvels of truly awful weather and systemic market meltdowns have a lot in common. First they feed on persistent disequilibria in their respective systems – weather systems feed on temperature and pressure differentials which can only be resolved through long time frames for adjustment or short term violence – storms. Similarly, economic and financial disequilibrium tend to be founded on regulatory or information impediments, leading to persistent positive feedback loops – first running markets up, and then, inevitably, leading to collapse.
Awful weather – a self-feeding phenomena
Really chaotic behavior in weather systems and financial markets requires that several positive feedback phenomena – think low interest rates, rising housing prices, systematic mispricing of securities, failed regulation, and systemic level fraud – are required to produce a real financial apocalypse. What makes the process interesting is that these factors may exist in the system functioning perfectly for decades, and only when combined a special brew a la the Three Witches of Macbeth do we get the resultant fiasco.
There has been a steady stream of metaphorical comparisons of Sebastian Junger’s book, The Perfect Storm, with the Great Recession in general, and the meltdown in sub-prime mortgages in particular. It is worth taking a look at what actually made the Perfect Storm unique, and what comparisons are meaningful to the sub-prime meltdown vis-à-vis complexity theory.
If they merge – you get the perfect storm
The Great Recession is a rolling disaster that the world economy seemingly stumbled into in the spring of 2008 led by a housing collapse which began in the sub-prime mortgage market. This rolling economic Verdun was born many years before in a series of ill-conceived and poorly understood policy initiatives championed by consumer advocates and industry groups alike. These reforms – generally characterized as deregulation – were targeted at the seemingly laudable targets of risk mitigation and fairness, and categorically achieved just the opposite. In this paper I take a look at the human faces behind the fiasco, it takes clever and dedicated people to create a mess this big.
A result of negative feedback
Each of these examples is a terrific case study of chaos theory at work. In chaos theory, a small action/change in a complex/dynamic system can have enormously disproportionate impact in the future. The classic example is posited by Lorenzo in his 1972 paper, Predictability: Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas? What is most important to remember here is that chaos theory is very sensitive to initial conditions, and unpredictable beyond very short periods of time. For those making economic policy this requires a constant vigilance for the undesirable unintended consequences of policy changes – clearly the butterfly did not intend the tornado.
It is to the quest of finding Lorenzo’s butterfly that I dedicate this series of articles.
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