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Wednesday, October 29, 2008

Aspects of markets and a free market system

In discussions over various ideas about political economy people bring a variety of notions and observations to the table. I try to look at history, data, and theory as they relate to events and the actions of individuals and groups. One of the mental models that I keep in mind in light of this is based upon the concept of complexity. A comment on this post made me think about it again:
Unsupervised markets always crash.
That is not a particularly shocking observation to my mind. The implication might be that supervised markets don't crash. My thought is that they just take longer to get to a point of criticality. Complex systems tend to exhibit a behavior called self-organized criticality.

Ming the Mechanic offers this:
We might over-simplify things for our purposes and say that there are three kinds of states of a system:

- equilibrium
- criticality
- chaos

If you poke at a system that is in equilibrium, nothing much happens. Or, if something happens to it, it would tend to go back to the same state as before.

If you poke at a system that is in chaos, something random will happen. If you poke at a system that's bordering on chaos, obviously something very random and chaotic might happen.

If you poke at a system that is complex, in particular one that is self-organized criticality, something is likely to happen. Probably something small, but maybe something big.

Despite that we've talked about avalanches and earthquakes, it should be stressed that the critical state is not chaos. It is not just some random catastrophe. It is ordered, although not in a way that's very transparent to us humans.

The critical state is also robust. It is always on the edge, but the edge is stable, although changing.

That might be hard to wrap one's mind around. Think about a wave in the ocean. It is neither in equilibrium nor is it chaotic. It is critical. It is the edge. There are small waves and big waves. They're all connected. If you watch a particular wave, it is moving, but it remains coherent as a wave, at least until it eventually crashes on the beach. If you're a surfer, you can catch a good wave and ride on it. When you're done with it, you can catch another. Waves are not random, they don't just come out of nowhere. You might not understand exactly how a wave came about, but you can learn to have a sense of whether one is coming, and you can catch it.

Social networks seem to self-organize towards criticality. They follow power laws. There are many small events and few big events. All sorts of frequencies are mixed together. There's a relatively pleasing pink noise. The network dynamically self-organizes itself into the most efficient state it could, without anybody being in charge. Many relationships have formed. The many actions of many individuals have woven a web of complexity. The network has over time become wound up in many ways.

So, in a complex social network, if you do something, something might happen. Something is more likely to happen than if all connections were random, or if it was neatly ordered in some very balanced way. Mostly small things happen, but there's an opportunity for big things to happen. You drop a message to somebody else, and if it is the right kind of message at the right time, the network is ready to allow a chain reaction to happen. Millions of people might be talking about it tomorrow. No guarantees, but the network is ready for you.

We ought to understand all of this better, of course. It seems to be a human tendency to try to fight against it. Central banks try to keep the economy in a perpetual equilibrium. Industrialized farming tries to grow just the crops we think we want, and nothing else. We try to organize things so that nothing bad ever happens. But we might at the same time be sabotaging the mechanisms that allow great things to happen.

We might need to learn to surf on the edge of the wave of complex change, rather than seek in vain the safety between the waves.
Technically, the region between equilibrium(very simple order) and chaos is called complexity and a point just before a major change is called critical, otherwise not a bad take.

Per Bak gives us this

There are reasons to suggest that socio-economic systems might organise themselves into a critical state with avalanches of change at all sizes via which dissipation mostly works itself out. This is a proposition to be tested but already statistical data like that found by Mandelbrot, Moss and Lux suggest that some variables change via avalanches of all sizes and that the power law distribution describes behaviour for some of these variables. Avalanches may serve, for instance, as a means of dissipation for the internal forces in markets.

A socio-economic system might become catastrophically unstable if the system were manipulated and forced to attain a certain optimal state interfering with its natural dissipation process. This has been observed in centrally controlled economies like that in Russia. However, it does not mean that any external control or influence generates this kind of 'negative' consequence. If an economy were a critically self-organised system, it might be controlled in such a way as to take advantages of its SOC properties. For example, it might be the case that in a weak economy (highly dependent on foreign markets), such as those in developing countries, some controls to protect the country from variations in the markets would help in changing towards or remaining on a 'good' development path. Better understanding of the dynamics of self-organised systems might allow to enhance those factors that minimise the number of large avalanches by channelling system dissipation through more frequent avalanches of small size.

FYI, Mandelbrot on finance , more and a good interview plus John Tierney gives mention.

We are quite likely dealing with an evolved system of fractal dimension in financial markets, the economy and the broader society. If so, rules, regulations and institutions oriented towards resilience and adaptation might serve better than those focused so intently just upon stability and they will need changes to keep up with an evolving world.


Harry Eagar said...

'regulations and institutions oriented towards resilience and adaptation'

Welcome, New Dealer. Now, go back and read Rex Tugwell and find out that your post is not so novel, nor that conditions today are so greatly different, functionally, from what they were when the Columbia agricultural economists examined how markets actually function -- as opposed to Smith's mysticism -- in the '20s.

(The Socratic method works, but slowly.)

Bret said...

Except that the 'regulations and institutions' of the New Deal were very focused on stability.

Which only leads to bigger critical events later.

Which is what's happening now.

Harry Eagar said...

Except that you are conflating two separate parts of the New Deal (no surprise there, my only question is whether rightwingers know they are doing this or just don't know anything about the New Deal; see Amity Shlaes).

The part aimed at stabilizing (or as they considered, reflating) was designed to be scrapped and was scrapped.

The mild regulations and institutions like the SEC were designed to be permanent but flexible. The lender-of-last resort provision was so successful it was almost never used (and never for its intended purpose) until, like soma, its origin and function were forgotten, to be replaced at need with something that looks sorta like it but isn't it.

It is beyond belief that you are attributing 'bigger critical events later' to a period nearly 20 years after the New Deal mechanisms were abandoned. Why not attribute them to proximate causes?

Well, I know why you can't. But it looks funny.

Anonymous said...

"The part aimed at stabilizing (or as they considered, reflating) was designed to be scrapped and was scrapped."

Weren't those scrapped because of Court decisions and other externalities, rather in accordance with a design? Temporary government measures are a rare thing indeed (almost as rare as a non-crashing free market).

But I think a bigger question is, which is better — a system that regularly crashes but overall yields better economic results, or a more stable system with lower average returns but less crashing?

Howard said...

It is one thing to realize that adjustments in a market system can be rough, even brutal in a way not envisioned in an idealized version of reality. That is why I advocate for a mixed economy with a safety net, a central bank and temporary relief for sectors in extreme distress. It is another thing to imagine having significantly greater knowledge and insight beyond that observation. A mechanistic notion of a broken machine is a conceptual framework that falls far short of a complex evolutionary one. (input-output tables rely on a fixed view of things) A large part of what the New Dealers did was to cartelize as much of the economy as they could get their hands on. The problems of competition were emphasized and the benefits greatly under appreciated. They were very much in style with the notions of central planning. Anyone part of the in group of a cartel was fine, people of the out group were put at a real disadvantage.

The Socratic method is very powerful. Since much of good economic thinking entails asking, "and then what," the questions have to go on and on. Bastiat described this as 'that which is seen and that which is not seen.' That which is not seen, rarely comes up as a question. This can be taken even further when considering complexity and the evolutionary nature of things. Perhaps this is why many of the best thinkers on societal matters are polymaths.

Harry Eagar said...

Yes, they were killed off by the court, but as designed they were meant to be temporary.

Yes, it is sometimes difficult to kill off temporary expedients (think of Ike wrestling with the farm surpluses).

But considering the considerable clout of the US tradition of competition, not impossible.

I haven't the slightest doubt what the proper answer to your question is, Guy. I'll swap a little bit (very little, as it happens) slower growth for a system that does not punish the innocent.

Besides, as I've said, the main limit on growth in the US over time has been shortage of labor, and no amount of free capital can beat that.

'That is why I advocate for a mixed economy with a safety net, a central bank and temporary relief for sectors in extreme distress.'

Very close to what I advocate as well. But I doubt we define 'safety net' the same. I am on record as saying that I hope the fools who created the current mess end up on the sidewalk selling pencils out of a tin cup, but despite the fantasies of the Smithians, that isn't the way it works.

Success is not rewarded and failure is not punished. Non-participants suffer the most and benefit the least.

As system that did not soar so high but also never crashed would, at least, harm the non-participants less than the current system.

In my county, I am looking at thousands of people who never went near a subprime mortgage, never heard of Wall Street, don't even have bank accounts, being ruined.

Hard to admire a system that works like that.

Hey Skipper said...


Anyone part of the in group of a cartel was fine, people of the out group were put at a real disadvantage.

Is the Wagner Act an example?

I'll bet it is, and its legacy is killing the Big Three.


I haven't the slightest doubt what the proper answer to [which is better — a system that regularly crashes but overall yields better economic results, or a more stable system with lower average returns but less crashing?] is I'll swap a little bit (very little, as it happens) slower growth for a system that does not punish the innocent.

The first part of that you leave unsupported, and the latter is attainable only through utopian schemes.

And we know how those worked out.

There is no such thing as a system involving humans that does not punish the innocent. I stand a reasonable chance of getting punished myself, despite living a life of economic virtue.

Why? Because politicians undercut the traditional requirements for mortgage lending. Because China fixed the exchange rate for the RMB far below what it should be. Because lots of mortgage companies provided mortgages to people too stupid, undisciplined, and greedy. Because investment bankers apparently don't know squat about the risks of leveraging, opacity, systemic risks, or economic history.

The problem, which AOG raised and you did not answer, is how to provide regulation that will act as a flywheel on the market without either being a brake, or a deadweight irrelevancy. (Sarbanes - Oxley, anyone?)

For instance, how is it possible to regulate against the huge foreign reserves the Chinese government accumulated?

How is it possible to regulate against glassy-eyed stupidity behind the CRA? Put more precisely, how does one regulate the regulators?

Well, for one, it requires understanding that periodic crashes are a concomitant feature of markets, and markets are far better at wealth creation, especially for the innocent, than anything else yet devised.

Something along the lines of insisting upon countercyclical reserve requirements (and, for the regulators, countercyclical spending), transparency, and watching out for excessive leveraging.

Hard to admire a system that works like that.

Per the Economist, even taking this credit crisis into account, thanks to this system working like that, over the last decade, more people have emerged from poverty than ever before.

Perhaps my admiration is more easily provoked that yours.

Harry Eagar said...

How the system works, from Bloomberg:

'For some bankers, a smaller payout [of bonuses predicted to total $20B] would come as a surprise. More than one-third of Wall Street employees surveyed by a recruitment Web site between Oct. 13 and Oct. 21 said they expect a bigger bonus this year. Two-thirds of the 1,300 people surveyed said they still expect some year-end award, according to, owned by New York-based Dice Holdings Inc.'

Those would be the bankers that the innocent are giving $125B to. I could fix that problem with a phone call and save myself $125B.

I have a program that eases up on the curves, both ways, and we know it works because for six decades the US enjoyed superb growth rates and no crashes.

If you guys are going to argue that maximum peaks, and damn the bottoms, is the way to go because of the necessity to reward the virtuous, then you are morally obliged, it seems to me, to figure out how to punish the wrongdoers.

That's whether you take 'wrongdoing' to mean turpitude or just guessing wrong in the bucket shop.

If the system is set up so that the innocent lose either way, I'd join them in stringing up the capitalists from the lampposts.

Hey Skipper said...

It isn't at all clear to me that "For some bankers ..." constitutes how the system works, or the resilience of expectations.

Regardless, insisting there is some sort of utopian system where the innocent don't suffer sounds like further flattening an already well worn path to the abattoir.

As for the innocent, they don't suffer either way. There are hundreds of millions of people no longer impoverished insisting to the contrary.

I'm not sure which program you are talking about, but insisting that mortgage holders have some dog in the fight -- which they did for six decades -- would stopped the words "sub-prime mortgage" ever darkening our discourse.

If you guys are going to argue that maximum peaks, and damn the bottoms ...

Who, other than a platoon of strawmen, is making that argument?

As for punishing wrongdoers, lets start with those who foisted the CRA upon us, and then compounded the error by (IIRC) insisting GSEs buy the subsequently toxic mortgage backed securities. And, while you are at it, we need to round up the Chinese gov't for their persistent refusal float the RMB.

Then we can talk about who else needs punishing; best, though, to get the cause and effect relationship straight.

I'd join them in stringing up the capitalists from the lampposts.

That has worked brilliantly everywhere its been tried.


Howard said...

hey skipper,

Yes, The Wagner Act was part of the cartelization. The financial system was also effected...

Consider the savings-and-loan (S&L) debacle of the 1980’s. The crisis, which erupted only two decades ago but seems all but forgotten, was almost entirely the result of a failure of government to regulate effectively. And that was by design. Members of Congress put the protection of their political friends ahead of the interests of the financial system as a whole.

After the disaster of the Great Depression, three types of banks still survived—artifacts of the Democratic party’s Jacksonian antipathy to powerful banks. Commercial banks offered depositors both checking and savings accounts, and made mostly commercial loans. Savings banks offered only savings accounts and specialized in commercial real-estate loans. Savings-and-loan associations (“thrifts”) also offered only savings accounts; their loan portfolios were almost entirely in mortgages for single-family homes.

All this amounted, in effect, to a federally mandated cartel, coddling those already in the banking business and allowing very few new entrants.

(much more in that article including how and why that arrangement came apart)

Harry Eagar said...

'As for the innocent, they don't suffer either way.'

That takes my breath away.

They are suffering terribly where I live. Some are losing their houses, some cannot afford to buy food.

Hey Skipper said...


As for the innocent, they don't suffer either way. There are hundreds of millions of people no longer impoverished insisting to the contrary.

Why does that take your breath away?

Capitalism is the only reason all those innocents which rend your heart so do not live in grinding, Malthusian poverty. So, when I say that these presumed innocents do not suffer either way, it is with respect to what those who would still be alive would have to tolerate otherwise.

This, in a para, highlights the weakness of your relentless critique so far: focussing entirely on capitalism's debits, and not at all on the credits.

As for those suffering terribly where you live, besides putting their suffering in perspective to the standard against which it should be truly judged, how is it that they are losing their houses?

If, as I suspect is the case, they leveraged themselves into relying upon a continuously rising market in order to succeed, then they are just as guilty, and should be strung just as highly, as the capitalists you wish to see swinging in the breeze.

Middle of the week, the WSJ had a several page article on how the housing crisis is affecting the area around Silicon Valley. Along the way, they did some personal profile stuff. One of the guys they talked to had taken a home equity line of credit out on his house, and spent it all on remodeling. His expectation was to recoup that money, and more, when he subsequently sold it in a rising market.

Ooops. Bad timing. He was suddenly upside down.

Now, there was absolutely no reason he couldn't stay in the house and continue making the payments -- his income was more than adequate.

But, no. He decided that didn't fit his retirement plans, so he gave it back to the bank.

There are hundreds of thousands of people, at least, who knowingly made themselves hostages to fortune, and walked away from the costs of their actions, despite being able to afford them.

Do they get strung up too? If not, why not?


Then, one wonders just how it is the "innocent" are suffering.

Here's my guess. One of the reasons we are having this crisis at the moment is due to pro-cyclical practices: lending more, leaving less (or, percentage wise, even the same) aside as reserves.

The counter-cyclical approach would be the opposite: in a rising market, set aside more reserves, both as a percentage and an absolute amount.

Government should do the same -- fiscal policy should be in the black when GDP is growing.

People, likewise.

The banks didn't. Government apparently won't.

People could, most don't. So when they are not able to cope with a downturn, despite having had the opportunity to provide themselves the means to do so, how innocent are they?

Harry Eagar said...

Well, let's say you are a Micronesian woman working in a resort as a chambermaid, paying $1,100 a month to rent a bedroom (without kitchen privileges), and because of the scoundrels on Wall St. you just got laid off.

Now, most likely in order to pay expenses, you also had a second, part-time on-call job, maybe helping to set up banquets. Only now there aren't any banquets.

So your income is down to whatever unemployment pays, a couple hundred dollars a week.

So you can keep your room, or eat, but you cannot do both.

There are at least hundreds and probably thousands of people just in my county in this fix.

They did not leverage themselves into silly loans. The Filipinos probably never even had a bank account.

erp said...

It was the scoundrels in the Democratic party beginning with Carter who led to the chambermaid's layoff. The scoundrels on Wall St. were the merely the auxiliary players.

A thousand plus a month for a room seems outrageously high. There must be more to this story and BTW isn't Hawaii a socialistic paradise? Why aren't there programs in place to help people who are laid off because of corporate greed?

Harry Eagar said...

No, nothing more to the story, except that unless you plutocrats want to scrub your own toilets on vacation, you need to devise a system to keeps the chambermaids off the streets.

Hawaii is not a socialistic paradise. For generations it was run by corporations -- the Big 5. It has a very pro-business Republican governor.

And you need to get over your obsession with mortgages. The financial crisis is the result of untransparent, unregulated transactions. This is pure capitalism. Hedge funds are not regulated at all by anybody.

The agenda of unsupervising financial markets is also known as Reaganomics.

Really, you guys need to start understanding that mortgages are a symptom, not a cause.

erp said...

If you mean me, I'm not obsessed with mortgages, I'm merely assigning the blame for the financial crisis where it belongs and unless the CRA and the mindset that invented it, are wiped out, there will be more melt downs in the future.

Of course, that's what the left is waiting for, so their takeover can be complete.

We, the Sheeple, will trade our freedom for their security. Thank God I won't be around to see it.

I feel confident there will always be enough service people for tourists' needs. Where did I get the idea that Hawaii had reached the level of workers' paradise? Oh, yeah! I read it in the paper.

Anonymous said...

"The financial crisis is the result of untransparent, unregulated transactions. This is pure capitalism. Hedge funds are not regulated at all by anybody."

The crisis did not come out of the hedge funds, so your second half is wrong. The first half is wrong because the reason financial institutions thought those transactions were a good idea is because they were presumed to be ultimately backstopped by the FMs. Absent that, vastly fewer of the junk would have been around and we would hardly have noticed the bump.

I find it interesting that "capitalists" are morally responsible for their own actions and those of government officials, while the latter are apparently not responsible for anything they do, nor are their elected official bosses. How did the capitalists end up with all of the moral agency? Bought in an unregulated, opaque transaction?

Hey Skipper said...

I find it interesting that "capitalists" are morally responsible for their own actions and those of government officials ...

I also find it odd that "capitalists" does not include all those people who treated the housing market as a casino.