Schrödinger's Kitten

Irreverent Science for Everyone

Friday 17 September 2010

Why The Credit had to Crunch - Or, Ye Cannae Defy The Laws Of Physics

  • policy
  • economics

Economics may be a dismal science, but it’s still a science, and so I consider it within my remit. Disclaimer: Everything I know about economics in general and recessions in particular I taught myself from library textbooks and online resources and going to talks. However I did teach myself about it and so that makes me more educated on the subject than Some I Could Mention.

Damn The Whole Wunch

There is a great mood of hating bankers at the moment. Iron Maiden explained for the hard of thinking present at Sonisphere that their latest release, 'El Dorado' — featuring the lyrics:

I'm a banker's face / With just a letter out of place

was about the financial industry (and meeeeetaaaaaal, naturally.)

The free papers (AKA what momma trees warn their young saplings about to scare them into being good) have been particularly enjoying announcing the large salaries and bonuses of city CEOs, managers and other flocculates1. Especially when they can accompany them with photos of lingerie models.

Generally the feeling is that by encouraging reckless borrowing, and by creating complicated financial instruments 'that noone understands' to abstract the whole affair to rarified, oxygen-starvation levels, the bankers caused the crash.

However, if we want to get all facty about it, they didn't. Sure, the high street banks and credit card companies are guilty of leading people into impossible levels of credit (there are 9 million more credit cards than there are people in the UK) and lacking transparency to the point of being deceptive in their dealings — but when these people were abstracted to the point of products (as people often are in big business), the financial world just did what everyone does, writ large. The higher echelons, the CEOs and traders who are bearing the brunt of the criticism, couldn't have done what they've done without the delusions society relies on.

Enough is Not Enough

What drove the financial industry to enter a more risky business? Greed is the answer we've been given. But capitalism is inherently greedy. Our country's GDP must keep going up, the company's profits must increase constantly, our computers must be faster with more storage and cheaper. It's not enough to be making sufficient, or even generous, returns; we demand continual growth.

Growth for the sake of growth is the motto of the cancer cell. Things cannot keep increasing, because resources don't keep increasing. The tumour requires more energy to keep multiplying, and the body loses out.

The corporation must keep returning more profits, so costs must drop or sales must increase. The factories are moved to cheaper cities, then cheaper countries, and still costs must be lowered so they don't even pay the pittance which constitutes a living wage there. Or market share must be snatched from competitors, because there is only so much spending power available — if someone gains, someone else must lose.

As infant mortality drops and food production increases, the human population increases. This is welcomed, as these new workers will support an increasingly ageing population; but they too will age and the next generation will need to have even more children and work them harder. And the next, and the next. We want more for our individual selves as well; a raise, bigger returns on our investments, a better house, more expensive handbags, a lovely lovely Bengal... We want to keep going up and up and up and never come back down. But that is not the way nature works.

What Goes Up Will Crash Down

Sure, in the wild populations increase. If there's a good summer and a lot of grass, the rabbit population will flourish and grow. On the other hand, this will be bonanza time for the fox population, which will also expand, and as they chow down on rabbit pie, they'll bring them back into check. As food supplies drop off the foxes will run out of food, have fewer cubs, or maybe die of starvation. Predation drops and the rabbits are off again. Population fluctuations are natural, but they are limited and will always return to square one.

Although we can say for sure they will drop back down, precisely when this will happen is hard to say. Ecological studies of population cycles show that they can follow a chaotic pattern. In a chaotic system, small changes in the way it starts out translate to massively different outcomes. A system like this does not follow any regular patterns and cannot be predicted.

The financial system is man-made, true: but it behaves in a chaotic way just like a chaotic natural system. In fact, a fundamental property of chaotic systems — that when graphed they produce fractals, shapes that retain their complexity and characteristic shapes no matter how much one zooms in — was discovered when Benoit Mandelbrot was studying the fluctuations of cotton prices on the stock market. This isn't so surprising — we are 'natural' and chaotic creatures, and our creations, particularly the ones we participate in, retain some of that character.

Risk Is Not Just a Family Board Game

So we have a tool which is inherently unpredictable and bound to crash sometime. Following the well-known principle that just because something is thought to be impossible is no reason not to do it, the financial industry attempted to control it.

In a 1973 paper, two economists called Black and Scholes published a paper which described how to price financial instruments. One product of this was a way to calculated a rational cost for an 'option'. Options come in two flavours — a 'call option', which grants the ability, but not the obligation, to buy a stock at a certain price some time in the future, regardless of the market price it is trading for at that time, and a 'put option', which assures the owner of the option to sell stock at a certain price at a given time.

This produced a theoretically fool-proof way of hedging your investments, by teaming your investment in a stock with options — and this is the clever bit — that go the opposite way. So, if you buy stock outright, hoping to profit when its price rises, you could match it with a put option, which will pay out if the price drops. Balancing this way enables you to be your own insurer.

It was known that this was just a model, and not a mirror of the real world: but armed with this and its descendants, financial mathematicians felt they could very much reduce, or even annihilate, the risks they were taking with their investments.

Given the nature of chaos hammered home above, this may seem hopelessly naive (although it's still going on in every office in the City even now). But ever since people were sacrificing other people at midwinter to ensure the warmth came back, humans have been trying to control the world around them. People are unhappy with, and notoriously bad at judging uncertainty and risk, so we try and reduce it. We consult the weather forecast in the morning, even though it's not much help. We eat antioxidants to save ourselves from cancer, even though they're not proven to do anything in extract form and there are many forms of cancer that don't respond to them.

We live not knowing what's going to happen day to day and we don't like it. We want to be given a list of things to do to keep ourselves healthy, a promise that our houses won't flood, specifics about the way the climate will change and the precise minimum we can reduce our driving by to retain beach front property. Is it any wonder that the financial system offered us certainties too?

And The Consequence Was

With the benefit of hindsight, not only did these financial techniques encourage people to think there wouldn't be a crash, they also made the inevitable come-down harder. Black-Scholes relies on the ability to sell short2 or take out put options as the market falls, thus covering yourself for any losses. But when the market is crashing, everyone agrees prices are only going to go down and so there's no one who'll take you up on those deals.

This highlights the problem with current economic models: they describe the behaviour of rational individuals, who are noticeably absent on Wall Street, Threadneedle Street, and indeed in the world at large. Phenomena such as the panic of a market crash or the herd behaviour of investors are excluded as irrelevant, psychological factors. This means that what economic models in fact predict is the behaviour of economic models. Which is all very well and good but we're not investing or living in economic models.

Of course, this isn't unique to economics; loads of things are too hideously complex for us to handle, so we build the best simulation we can and run with that. Just look at climate modelling, a classic example of something too important to ignore but too complicated to cite hard figures on. It's not a reason not to try and create simulations and improve our understanding, but it is crucial to understand and accept our limitations. People are trying to develop more realistic economic models incorporating real human behaviour, but this is still in its infancy.

The Bottom Line

In summary, there is no point in hating or blaming the bankers for our own self-destructive habits. The bankers were the ones who sold us the products, but only because we wanted them to. We asked for constant growth and a risk-free future, and we should have been careful what we wished for. The financial institution's excessive trust of their models and lack of caution in their application made it worse but it didn't cause it. Lean times happen.

If you still want to be angry at something (and who doesn't?), you've got a couple of options:

DISCLAIMER: I do not actually advocate doing all of these things and if you do it's nothing to do with me.

1. Flocculates are the soft accumulations of particles in a suspension that gather together. Like cream rising to the top, but for sewage coagulating in the middle.

2. Selling short is when, sure that the price is going down, you borrow shares now, and sell them at the current price. When the price has dropped you buy some more shares now they're cheap, give them to the sap who lent them to you, and trouser the profit. It's one of the simpler financial implements and has the pleasing twist that there is no limit to the amount of money you can lose doing it.

3. I'm not really that misanthropic but sometimes I really do wonder why we do these things to ourselves.

Content: Scary Boots — Design: Canis Lupus