Wolfram and Financial Regulation

Posted by: Michael Mandel on July 23

This may be too wonky, but here goes…

Remember that earlier this year I was rereading Taleb’s The Black Swan. I drew some conclusions about technology and financial regulation. First, Taleb helped me understand what it means for technological change to be fundamentally unpredictable. Second, I got new insight into the best way to do financial and economic regulation.

In the same vein, I was just rereading Stephen Wolfram’s <em>A New Kind of Science,and I was struck by its applicability to our current situation. Wolfram argues that:

even though the underlying rules for a system are simple, and even though the system is started from simple underlying conditions, the behavior that the system shows can nevertheless be highly complex.

How does this apply to today’s economy? From my perspective, Wolfram shows that a set of simple rules can produce both ‘near-random’ behavior and ‘near-regular’ behavior, depending on the initial conditions and how long the system has been running. Near-regular behavior means that there is some predictability about what’s going to happen next—-the world feels sane and understandable. Near-random behavior means that the near-term future becomes effectively unpredictable—-there are no short-cuts, no rules of thumb about what is going to happen next. The ground feels unsafe.

In ordinary times, the economy and financial markets operate as if the world was near-regular—predictable and understandable, to some degree. Last fall, however, we suddenly fell into a zone of near-randomness, that we are still digging ourselves out from.

Why did this happen? One insight from reading Wolfram: Without changing the underlying rules, it’s possible for a system to evolve from near-regularity to near-randomness, without much warning. Or, it can go from near-randomness into a zone of near-regularity.

I think that we can be safe in assuming that most people and businesses prefer to operate in an economic environment which is ‘near-regular’. That is, where there is some degree of predictability about the future. On the other hand, few people feel comfortable living in a world which is ‘near-random’.

That suggests the role of regulation is to keep the economy and financial markets operating within a near-regular region. If we start drifting into a near-random region, financial and economy regulators have to be able to take action in order to steer back into the near-regular region again.

So what can the regulators do? First, they can simplify the rules of the game so much that the economy and the financial markets become predictable. That might mean moving to a system of ‘simple banks’ which can only take deposits and make straightforward loans.

The other alternative is to find a good regulatory strategy by trial and error. Following Wolfram’s insights, we have to actually run the economy and the financial markets under that regulatory system to see if it produces the desired results. There are no short-cuts—unless we are prepared to greatly simplify the financial system.


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Reader Comments

Chuck Brooks

July 23, 2009 03:03 PM

As Walt Wriston observed, '...rules made by men can be unmade by men...'. Regulators will do what's best for regulators and their agencies, a fact of life and a consequence of the latest PC (as in Public Choice).
Chuck Brooks
FutureWare SCG

Ajay

July 23, 2009 11:00 PM

I think it's folly to extrapolate from Wolfram's observations about simple mathematical rules to something as complex as an economy. The fact is that it was obvious to anyone with a brain, a distinct minority, that housing prices were in an unsustainable bubble earlier this decade. I know this because The Economist wrote several articles BEFORE the 2004-5 peak comparing the real estate runups around the world to past real estate booms, such as the Japanese one in the '80s. Your delusion is that regulatory agencies can or would want to evade such irrational bubbles, which after all might not have been unjustified if they had coincided with another tech boom, especially considering that quasi-govt agencies like Freddie and Fannie jumped into subprime and further made the housing situation worse precisely when it was obviously a bubble, egged on by Barney Frank and others clamoring for more "affordable" housing.

I do agree that changing banks is the solution, only I suggest the opposite, ;) that they should not take deposits that they then loan out, whether checking or savings deposits, and should only use CDs and other instruments that have defined maturity dates of at least 3-6 months to bring in money for loans. The reason banks become so important is that fractional-reserve banking is plagued by bank panics, where depositors can pull all their money at any time and at once, leading to banks collapsing like dominoes and shrinking the money supply in the process. Most money today is susceptible to this problem, with the Fed estimating that $5.3 trillion of the $8.37 trillion in M2 being held in such deposits, most of it surprisingly in savings deposits, more if you also count the $1 trillion in retail money funds which can also be redeemed at any time (http://www.federalreserve.gov/releases/h6/current/h6.htm). I think we'd be better off if the public were properly informed of the dangers of fractional-reserve banking, a subject about which 99.999% are unaware or do not understand, and most would probably then choose to use full-reserve banking or at the very least much higher reserve ratios, where the banks simply store most checkable deposits without loaning them out and only use CDs with defined maturity dates for loans, limiting the effects of a panic. As for limiting banks to straightforward loans, that's almost impossible to define as a regulation and is a silly suggestion. After all, it was the financial firms' gaming of the credit-rating agencies and their AAA ratings that were mandated by govt regulations that helped cause this mess in the first place. Finally, most of the current problems were caused and exacerbated by investment banks such as Bear or Lehman, not commercial banks, though the mechanism was the same, fundamental instability because they were borrowing short-term through the repo markets, funding which was then pulled abruptly just like a classic bank run. I don't think we need regulation to fix any of this, I think we need to properly explain these mechanisms and let people make their own decisions. After being burnt recently, I suspect most will understand and listen.

LAO

July 24, 2009 09:57 AM

Thanks for the NKS reference; I somehow missed this whole thing.

I take some small comfort from your assumption that "most people and businesses" would prefer a 'near-regular' economic environment. I would assume the same, but the behavior of those with the power to make it so suggests that they either believed otherwise or were fools.

Joe Cushing

July 24, 2009 08:12 PM

AJ makes good points

"Your delusion is that regulatory agencies can or would want to evade such irrational bubbles," The point about bank runs is interesting too because we have insurance that is supposed to stop that. The insurance doesn't stop bank runs though and it causes a moral hazard.

one point is missed though. Sure people will learn from their mistakes just as they did in the 1930s. Then they will die of old age and the next generation will think they are invincible.

I don't think there is anything that can be done to stop market booms and busts. I think we benefit from them as much as we are hurt from them. I say, lets not try to stop them. Instead lets try to cushion the blow to people when it happens. People need emergency funds. I'm not sure how to get people to save them up though.

Ben

July 27, 2009 07:40 PM

Yes, good points made in Ajay's comment. Also some assumptions about the intelligence of the masses. In a democracy isn't the LCD (lowest common denominator) frequently going to swing decisions one way or the other? People making rash decisions based off of emotions related to the largest financial crisis in 80 years aren't going to be well informed or thought out.

Domestic savings are a travesty, people forget that a portion of this century's prosperity will be paid for on the savings of last century's labors. Which, in sustainability terms, means we're in trouble barring some very drastic changes.

Dominic

July 29, 2009 03:55 PM

For the first time I have to completely agree with Ajay about the issues with FRB.
It would be interesting to explore the feasibility of a full reserve banking in a modern economy.
Personally, I would gladly trade some percentage points of economic growth in exchange of less volatility and less pronounced boom and bust cycles.
Economith growth more based on real productivity improvement and less on "froth".

Thank you for your interest. This blog is no longer active.

 

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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