The Connected Economy

As the financial markets battle the fallout of years of poorly regulated unwise greed, the language of analysis is revealing. Commentators talk of “contagion spreading“, financial “gears jammed“, and “turbulent” markets. This is the language of non-obvious connection, where it’s theoretically possible but impossible in practice to predict the future state.

Listening to This American Life’s new episode on the spreading financial market failures brought this home. It talked about Credit Default Swaps (CDS) and how hedge funds would both buy and sell these so that they were making money from the interest even as their clients were covering each other’s principals. This worked fine for a while, but because hedge funds were each others’ clients there arose these long lines of dependencies—if A failed to pay B, then B couldn’t pay C, who couldn’t pay D, and so on. When the markets started to choke on rotting mortgages, the CDS chains began to unravel.

The CDS game was a bugger because it was easy to check one fund’s books and say “yes, we are covered”. But there was no way to identify these chains of dependency: the connections between funds were invisible. And, as it turned out, the connections between funds were so much more impotant. Just as one person dying isn’t as important as the fact that they can infect others, so too one hedge fund going belly up wouldn’t have been anything like the disaster of the dependencies. With globalisation, these connections can span markets, borders, currencies, and languages.

This newly-realized importance of the network reminds me of biology, where we thought we could understand an organism by mapping its genes. Now we realize an organism is a complex mixture of manufactured and transformed chemicals and even other organisms, and the genetic blueprint is necessary but not sufficient for understanding. You can no more understand how an organism works by reading its DNA than you can understand how San Francisco works by reading its phonebook. This “whole organism” multi-level integrative approach is called systems biology.

Nodes often aren’t as important as the connections between them. Reductionist science and analysis from the 19th and 20th centuries focused on nodes. I believe 21st century science, economics, political science, and computer science will use more complex systems theory to understand the interactions between chemicals, speculators, nations, and users.

Social network mining, exemplified by Duncan Watts‘ six degrees work, is just the tip of the iceberg. I think this kind of modern network analysis can make the world a safer place, our futures more secure, and even our bodies more comprehensible. In 100 years time, historians will say that this century’s Einstein, Watson, Crick, and Feynman were students of network analysis, and that this was the Connected Century.

  • stretchy54

    I agree with your view that the “connected century” should embrace holistic analysis techniques. Perhaps today’s economics students should immediately withdraw from their Micro- and Macro-Eek-Anemics Theory courses and demand to be taught the new complex network systems theory mindset.

  • Dennis Linnell

    Good post, but “unwise greed” is only a small part of the story – unwise structure and leverage play dominant roles. The connectedness you mention is no different from tight coupling in software. We exhort software engineers to avoid tight coupling because of the inherent potential of instability. Yet regulators, risk managers, and “financial engineers” turned a blind eye towards the possible domino effects of connectedness, even though they knew better. Now we suffer the dire consequences of such inattention.

  • I disagree that networks, connections between things, have not been studied extensively before. For examples, we could go back to cybernetics in the 1950’s, ecology in the 1970’s etc. There was also quite a lot of theoretical work done by Stuart Kauffman in biology, amongst others in the 1990s.

    The other point I would make is that understanding doesn’t necessarily mean that we can use the system to improve our lives.

    In the case of finance, there was plenty of understanding about safe lending rules, but the desire to change the rules for different payoffs created the change. As a simple analogy, you can choose the risk/return profile in your investment portfolio, knowing that the increased expected return comes with the increased risk of losing everything. You make a choice, that’s all.

  • @Alex great points!

    I would argue while know a lot about safe lending rules, we don’t know as much as think we do about calculating risk. Knowing the risk created or diluted by the network of trades could add a lot to our understanding.

    Trading firms won’t voluntarily open their books, nor should they, so calculating the network risk would have to fall to a trusted third party if at all.

    Let’s say each trading firm has a daily network adjusted risk measure, how would that change things? Would we regulate individual contribution to network risk like we do asset leverage?

  • Jo

    IMHO, there are many more systems than finance that come down to Emperor’s Clothes – but I don’t see people getting dressed!

    I suppose the whole point is that the Emperor doesn’t really get it – and we will see more crunches in other systems.

  • @Erich “I would argue while know a lot about safe lending rules, we don’t know as much as think we do about calculating risk.”

    I agree. This of course was the basis of Nicholas Taleb’s 2 books – “Fooled by Randomness” and “The Black Swan”.

    The issue of network effects was also raised by economist Mark Thoma on his blog – you can read the post here:

  • Well, In the era we are living with everything is connected with economy directly or indirectly ..

  • Stephen Stollmack

    I am trying to understand how 535 of our supposedly well informed and dedicated public servants, sent to Washington to protect our interests and make things work right, could have botched things up as badly as they have. What on earth do they do with their time and with their intellectual curiosity, if they have any?

    I got my degree in Engineering Systems at the Ohio State University in 1969 and, now that I am retired at 73, I am wondering why it has taken us so long to get the Systems view of the world to spread to or be accepted by those who are in positions of responsibility and power. Let me throw out a few possibilities:

    1.Knowledge about how complex biological and social systems are has made us humble and not anxious to dictate our thinking to others;
    2.People in power have inflated egos and believe that they can, with the proper allies, will their way to the “best” solution;
    3.The primary dynamic going on in the chambers or halls of our democratic institutions is not innovative thinking but rather one that has to do with:
    building a power base;
    voting so as to protect themselves from criticism from the lobbyists who helped put them in office;
    trading this for that with other members and constituencies;
    4.Everyone is looking for different authorities – people with experience and success in their field – to tell them the answers rather than to a way of thinking or an analytical approach to lead them to the answer and give them a common ground for discussing these problems with their colleagues. So, year after year, the system’s approach hides and puts its collective hands to its head saying “Oh my God, they did it again”.
    I mean, how else can you explain how, as we approach an economic Armageddon and ecological disasters, we have 4 people with so little to say about how to solve our problems, running for President and Vice President of America.

  • “Perhaps today’s economics students should immediately withdraw from their Micro- and Macro-Eek-Anemics Theory courses and demand to be taught the new complex network systems theory mindset.”
    This is absolutely true and I think it’s a global issue. There seems to be almost no difference between the US and EU for instance. We seem to teach even more retarded economics in Germany… All the knowledge sucessful business men gathered was out of the universities. Networks and connections aren’t taught anywhere, you have to be autodidact.

  • I can’t agree with Steven 100 %. You say that the education is somewhat retarded. That might be true if you look at school or the early stages in university, but the deeper you go in studies, the less retarded is the education. So in my opinion you don’t have to be autodidact because of the retarded system, but you have to change the way you learn. Reading books and writing tests is the best possible way to educate yourself. The practice is the most important factor German and European universities almost ignore.