How much can stock can we put in certainty? What causes financial panics? Most people blame politics, bad statistics or greed. Turns out it's more complex than that--but not all that complicated.
Last week we interviewed Diego Espinosa about how our quest for certainty has taken our market system to an unnatural place of positive feedback loops and financial inequality. We've unwittingly created a marketplace of "certainty merchants" who use the story of statistics to save us from our own anxieties--to the tune of bubbles and financial panics:
What is a self-organizing system?
A self-organizing system is a system in which order emerges from the different pieces in a network following simple rules and interacting with each other.
It sounds kind of magical. The types of patterns that emerge from that self organization are remarkable. It's all of evolution, it's ant colonies, it's human consciousness... That's what's so amazing about complex systems: networks are complex in the richness of their interdependencies, but the pieces are all following simple rules.
In a recent article, you talked about self-organizing systems and feedback loops and how their behavior impacts important systems in our world like financial markets, social networks, and even equality and inequality. Can you explain how a feedback loop can have such a profound effect?
Feedback loops are the basic building blocks of order created by complexity. The second law of thermodynamics says that things tend toward entropy, and in self-organizing systems they tend away from entropy and toward order. A feedback loop is another way to describe self-reinforcing behavior. So it's organic to complex systems to have those types of patterns.
The thing I find so interesting about inequality is that it emerges from a system of competition. All of a sudden we had a very high degree of inequality that emerged. How did that happen? There are all kinds of explanations and some of them have moral qualities to them, that people are greedy, bankers are greedy. I don't dispute that, I just don't think it's the fundamental cause of inequality. I think the fundamental cause is that you have a system that tends toward fairness for a variety of reasons, but can spark a feedback loop that tends away from fairness if certain things disappear from the system. In our economic system we've gone from relatively stable, tending towards an attractor, and phase-shifting into a positive feedback loop that goes to more inequality over time.
But what about our human agency to affect the system? How can we assign any value to one agent over another?
I like comparing things that happen in human systems to ant systems because they're social animals and they don't have agency. So when we compare the two, we strip agency out of the equation.
We do things consciously that cause unconsciously for patterns to emerge. Out of pursuing our self-interest, there are things that emerge that tend to create fairness in our society. I think that the market system has a fundamental aspect of fairness in it, which is that prices are transparent. If we're all standing at a crosswalk, rich and poor, we all get the signal to walk at the same time. So no one has the advantage. Market prices have that quality about them when they're transparent and highly visible, and that generally produces fair outcomes until something goes awry. And things do go awry.
How does this happen, and how do we put on the brakes?
The idea behind my article is that when feedback loops get engaged, there are natural brakes that exist in the system. If it didn't have these natural brakes, it wouldn't exist, because the inequality would get so bad that people would opt out of the system, have votes or revolutions for other systems. There are 3 fundamental brakes that kick in. The first is most important, and they get more drastic as you go on.
1. Competition - if we have a fair amount of competition in the system, it's difficult for inequality to persist. Competition over time will erode the economic rents produced by a lucky, successful company. We're in a positive feedback loop right now because our brake of competition has for a variety of reasons been taken away.
2. Political processes - people will vote for policies that bring more equality. If we don't get a political outcome that produces it, it means that something's wrong with the competitive system of politicians competing for votes.
3. Financial crises - because the wealthy keep most of their wealth in financial assets, financial crises come around and erode the value of financial assets and redistribute wealth. This is an example of a system without brakes undoing itself. Financial crises can be very chaotic - can incite revolutions and other extreme events. This is the last resort of the system to save itself.
Throughout history, we get punctuated financial crises and wealth doesn't last very long because a lot of it gets blown away during these times. Bailouts like we had in 2008, however, preserve the wealth of the wealthy because they prevent it from being destroyed during these financial panics.
Doesn't greed have something to do with financial crises?
But the greed is natural. Greed is part of human nature--it's just that sometimes that greed produces diversity in the network, and sometimes it produces homogeneity. When everyone starts doing the same thing it can be self-reinforcing.
We tend to think of financial panics as really bad things because they hurt people, and I understand that and sympathize with it. However it is also true that if we don't have them, that inequality will build up and build up, and that creates a basic sense of unfairness in society that is destructive to it. Personally, I'd rather see the pain of financial panics than the far more destructive power of a complete erosion of fairness and what that could produce.
Because there's order on a larger scale?
Yes, and because that order is more sustainable, and the financial panic is part of sustaining it. In his book Linked, network scientist Laszlo Barabasi talks about preferential attachment. The more activity part of a network has, the more connections it can establish. And the more connections it establishes, the more activity it has. That's a positive feedback loop. This tends to happen with wealth. The more wealth you have, the more opportunities and connections you have. The system tends toward inequality in that sense.
Part of understanding complex systems is understanding the way networks behave, and we have a network that tends toward preferential attachment.
How does a system, or a person in it, find resilience? Do we just become more adaptable to change?
Great question. I wrote a book about this question, because it led me down the path of thinking about human agency. As much as the next person, I don't want to be compared to an ant - I want to think that I have agency and some measure of control. The conclusion that I came to was that people can have agency, and having agency is part of the system. People should be adapting to the environment in such a way that it brings the network to homeostasis.
One of the big causes of inequality today is that people were used to having much more uncertainty in their lives before WWII. The way they adjusted was through a system of heuristics - don't buy too much house, don't get into too much debt, maintain strong social bonds.
So these common heuristics sort of wove people into each other?
Woven into their agency were social adaptations for resilience that kept the system in homeostasis. But something went wrong. By 2005, some home prices in California were 9 times the average income. What happened to the heuristic? From the individual's perspective, why did it go away?
The answer I came to was that people want more certainty in modern times. Post WWII, we went through a period where life just seemed more certain. There was prosperity, expansion, people felt comfortable. If you look throughout history, that was kind of a freak occurence. In the 1980s when things became much more uncertain, we wanted to hold onto the certainty. The way we did that was borrowing money.
"Let's buy the certainty!"
Yes. There was this super meta-trend at work - there's a group of people who want certainty in their lives, and they're willing to pay other people to procure it. The people that are getting paid to provide that certainty are getting very very rich. I call them the Certainty Merchants. That's the title of the book. The certainty merchants draw resources and wealth from the system by promising people certainty, but in reality it's a very inaccurate depiction of the system. You can have panics, the wealth can be destroyed...
Where did people get the idea that they could expect an 8% return on their investment year after year? Well, they got it from people like me. I was managing retirement accounts at that time. People today believe the story that probability and statistics tell them. In high modernism, something that Nassim Taleb talks about, our society came to be dominated by this idea that our tools for understanding the future are so powerful that we can have a higher degree of certainty than we've had in the past. I think that's a misrepresentation of the complex world we live in.
Think about all the advertising that's pitched to you about every major decision in your life - buying a home, buying a car, retirement... you're getting bombarded with a story about how you can have certainty about it. So it's natural you'd believe it.
So if a system is a reflection of us, then if people believe that we can have more certainty, the system itself will reflect that for a time.
Yes, and what will happen is we'll build up more and more debt as we feel more and more certain, so the bubble and subsequent 2008 panic was a blowoff of that 30 year build up toward certainty. So don't listen to the certainty merchants anymore. Take back your personal relationship with uncertainty.
How do we do that?
Get the answer in this week's episode, part 2 of our interview with Diego, this Thursday on the HumanCurrent...