Complexity in Financial Systems: Why Trying to Predict the next Crisis is Futile

Saturday, May 15 2010 by
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Complexity in Financial Systems Why Trying to Predict the next Crisis is Futile

We can probably all agree that modern day financial systems are complex, but what that actually means isn't something that everyone agrees on. Typically, though, a system characterised by complexity isn't something that anyone's designed – it emerges, it adapts spontaneously and it produces stunningly unexpected outcomes when no one's expecting them. Which, let's face it, sounds a lot like modern finance. The problem is that many economists are focusing on how they manage this system when, in reality, it's impossible to do so. It's like trying to contain swine flu using a butterfly net.

Complexity Is Not Engineering

When many people, including economists, discuss complex systems they often use analogies with complicated engineered systems like aircraft or nuclear power systems. Now these are definitely complicated, with many, many interacting parts, the failure of any of which may compromise its integrity. However, complicated human engineered systems are not truly complex. For the most part the designers of these systems go out of their way to make sure that they don't exhibit the trademark unpredictability and non-linear outcomes of complexity. Indeed, the very fact that these systems have a designer is a sure sign that they're not truly complex. This was the problem that Charles Darwin solved – how do complex things like human beings come into existence if not through the guidance of a designer? The answer, of course, is that complexity can arise through interaction with the environment as long as there's some means of adaptation. These are the trademarks of complex adaptive systems. Darwin was concerned with biological evolution, but the global financial system is of the same type.

Complex Means Adaptive

There are two noteworthy things about complex adaptive systems. The first is that they're complex. The second is that they're adaptive. And while that may be a statement of the bloody obvious it's one that seems to escape many financiers studying the subject. The ability of the system to adapt, often in completely unpredictable ways, means that you can't model it and you can't foresee the outcomes of any strategy of intervention. It's all completely unknowable in advance. Once you accept this it becomes suddenly apparent that a huge swathe of modern finance is complete rubbish. For example, in a complex system you expect to see "tipping points" or phase transitions when the system suddenly and unpredictably switches from one stable…

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1 Comment on this Article show/hide all

David G Wilson 17th May '10 1 of 1

Some complexity facts, not widely understood or embraced (as yet) within financial sector:

  • The amount of fitness of a system is proportional to its complexity – higher complexity implies higher fitness
  • The amount of functionality of a system is proportional to complexity – more complex systems can perform more functions
  • Each system can only reach a specific maximum value of complexity
  • Close to the upper limit the system is fragile – it is unwise to operate close to this limit
  • High complexity = difficulty in management – highly complex systems are able to perform more functions but at a price: they are not easy to manage
  • When a system is very complex and becomes difficult to manage, it is necessary to restructure it, add new structure or to remove excess entropy.
  • More components don’t necessarily imply more complexity – systems with few components can be more complex than systems with many components.
  • When presented with two equivalent options, for example in terms of performance, risk or profit, select the one with the lower complexity – it will be easier to manage.
  • Spasms or dramatic changes in dynamical systems are always accompanied by sudden changes in complexity.
  • In nature, systems tend toward states of higher complexity, but only until they reach the corresponding maximum. This poses limits to growth and evolution.
  • Systems with high complexity can behave in a multitude of ways (modes).
  • Systems with high complexity are more difficult to manage and control because of the need to compromise
  • A system with a given complexity will be more difficult to manage if it is made to operate in a more uncertain environment.
  • "High complexity is incompatible with high precision" – this is known as L. Zadeh’s Principle of Incompatibility. In essence, you can’t make precise statements about a highly complex system.
  • A fundamental characteristic of highly complex systems: they are robust yet fragile!


Of course it is not the "naturally occurring" complexity within financial services that has been the major issue. It is the "man-made" complexity in the form of opacity that has been the smokescreen for greed fuelled gambling.
If not a complete solution, at least a major step in the right direction is now available...

David
http://davidgwilson.spaces.live.com/blog/

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About timarr

Timarr

I'm a UK based technologist (career) and psychologist (academic) with a long-term interest in financial markets, with a particular emphasis (and skill) in how to not make money out of them. When I'm not working or blogging I'm to be found childminding, walking the dog or hiding in the garden shed with a good book :) more »


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