Avalanches, Nuclear Reactors & Financial Markets – A Complexity Theory View by James Rickards

Remember the beginning of the subprime mortgage crisis in early 2007? Economists, Money Managers, Financial Anchors told us that subprime mortgages were only a small portion of the US Financial sector. They assured us that the subprime crisis would amount to little more than a disturbance. They were correct about their first claim. Actual subprime mortgage losses are still less than $300 billion, a small amount compared to the size of the American Financial System.

But these experts were totally wrong about their second claim. As Mr. Rickards writes in his book, Currency Wars:

• “…when the avalanche began, everything else was swept up in it and the entire banking system was put at risk. When derivatives and other instruments are included, total losses reached over $6 trillion, an order of magnitude greater than the actual losses on real mortgages.”

How did the regulators and bankers miss this massive crisis? The political battle and the blame game is still going on. One reason might be, as Mr. Rickards argues in Chapter 10 of his book:

• “..the regulators and bankers were using the wrong tools and the wrong metrics. Unfortunately, they still are.

He thinks that what happened in 2008 was an example of a phase transition of a complex system in a critical state. The Financial Crisis of 2008 sped like wildfire and caused havoc in seemingly unrelated markets all over the world. The term wildfire is itself relevant. Forest fires that destroy million acres can begin with just a small spark and then create a chain reaction that creates a huge wave of fire that engulfs everything in its path. The term chain reaction itself describes the ultimate human nightmare, a nuclear meltdown.

How does this help us understand the 2008 Financial Crisis? And more importantly how does it help us ponder the next financial meltdown? The answers may come from Complexity Theory, a relatively new school.

This articles reviews the application of Complexity Theory to Financial Markets discussed by James Rickards in his book. Mr. Rickards is a counselor, investment banker and risk manager with over 30 years’ of experience in financial markets. He advises the Department of Defense, the U.S. Intelligence community and major hedge funds on global finance.

This article is about Currencies, Capital and Complexity or Chapter 10 of the book Currency
Wars. 

Why should you read this? Just look at the world today and remember what the world’s leaders told us after 2008. In
2009, the leaders in America swore never again. They vowed to take
regulatory steps to ensure that the financial crisis will not happen
again. The rest of the world took steps to ensure that the American
problems will not enter their regions.

Today, a mere three years later, Europe is engulfed in a much bigger
crisis. Last month, the Indian Rupee lost 17% of its value against the
U.S. Dollar in about a month in a free fall. The world seems perched on a
precipice of a global problem.

Mr. Rickards argues that Complexity Theory provides an understandable model that explains why the world’s financial problems are getting worse.

Concepts of Complexity Theory

Complexity theory rests on straightforward foundations, as Jim Rickards explains:

• Complex systems are NOT designed from the top down. Complex Systems design themselves through evolution or the interaction of myriad autonomous parts.
  
• Complex Systems have emergent properties. When systems are highly complex, emergent properties are far more powerful and unexpected. Jim Rickards illustrates this with an example:
• Climate
  is one of the most complex systems ever studied. Hurricanes are
  emergent properties of climate. Their ingredients, such as low pressure,
  warm water, convection and the like, are all easily observed, but the
  exact timing and location at which hurricanes will emerge is impossible
  to predict. We know them when we see them.
  
• Complex systems run on exponentially greater amounts of energy. When you increase the system scale by a factor of 10, you increase the energy requirements by a factor of 1,000 and so on.
• Complex systems are prone to catastrophic collapse.

In a nutshell, complex systems arise spontaneously, behave unpredictably, exhaust resources and collapse catastrophically.

This makes Complex systems very different than merely complicated mechanisms. As Jim Rickards explains,

• “a
  watch has gears, springs, jewels, stems and castings to make it
  complicated. Yet, the parts do not communicate with one another. They
  touch but do not interact. The behavior of one gear does not change the
  behavior of another gear.  Complexity is much more than complication.”

Financial markets are complex systems nonpareil. Mr. Rickards uses this example to illustrate the concepts below.

• Complex Systems begin with individual components called autonomous agents  which make decisions and produce results in the system.
  
• Millions of traders, investors and speculators are the autonomous agents. These agents are diverse in their resources, preferences and risk appetites.
• The second element is connectedness – the autonomous agents are connected to one another through some channel. The agents must have a way to contact one another.
  
• The millions of traders, investors and speculators are densely connected. They trade and invest within the networks of exchanges, brokers, automated execution systems and information flows.
• The third element is interdependence, which means agents influence one another. Mr. Rickards first gives the example of a person who looks out of the window and decides to wear a coat because every one in the street is wearing one.  Then he relates it to financial markets:
  
• When the subprime mortgage struck in early August 2007, stocks in Tokyo fell sharply. Some Japanese analysts were initially baffled about why a U.S. mortgage crisis should impact Japanese stocks. The reason was that Japanese stocks were liquid and could be sold to raise cash for margin calls on the U.S. mortgage positions. This kind of financial contagion is interdependence with a vengeance.
  
• We look at this property in another way. A classic case of agents or investors influencing one another is what is known as a “crowded trade”. For example, investors began pouring into emerging markets (or in technology-telecom stocks in 1999) because they saw others investing there. This interdependence is what is called in investing parlance as “Trend Following”, “buying new highs”, “buying strength” or “markets telling you what to do”. This interdependence taken to the nth degree turns into a bubble.
  
• The last element is adaptation. In complex systems, adaptation means more than change; rather it refers specifically to learning. This learning can be collective in the sense that lessons are shared quickly with others without each agent having to experience them directly.
  
• According to Jim Rickards, traders and investors are nothing if not adaptive. They observe trading flows and group reactions; learn on a continuous basis through information services, television, market prices … and respond accordingly.
• We look at this property in another way. This “adaptation” shows up in the fact that sectors or asset classes that led before a bubble take a long time before coming back into favor. This is why sectors that lead in new bull markets after a bust are very different from those which led before the bust. Cisco, the darling stock on the tech boom, is still 75% below the 2000 high. Today, we see people paying more to rent rather than buying homes or apartments. This is also true of young people who did not lose any money themselves in the housing bubble but have seen the what happened to other homeowners.

Autonomous Agents that are diverse, connected, interdependent and adaptive are the foundation of a complex system. Usually complex systems work well and continuously produce surprising results without breaking down.

This raises the question – why are complex systems prone to catastrophic collapse and how does a collapse occur? This leads us to the next concept.

Phase Transitions

Phase Transitions or rapid extreme changes are a way to describe what happens when a complex system changes it state. Mr. Rickards illustrates:

• When a volcano erupts, its state goes from dormant to active. When the stock market drops 20% in one day (October 19, 1987), its state goes from well behaved to disorderly. If the price of gold were to double in one week, the state of the dollar would go from stable to free fall.

Last month, we saw the state of the Indian Rupee change from stable to a free fall of about 17%.  These are all examples of phase transitions in complex systems.

Phase Transitions can begin and cause catastrophic effects from small causes. You don’t need a large cause or bolt to create a catastrophe. A single snowflake can cause a village to be destroyed by an avalanche. A single bolt of lightening can destroy a million acres. The key is not the size of the trigger but the state of the complex system at that time. That is the determinant of whether a small spark can start a small fire or a huge forest fire.

Critical State

The state in which a complex system is poised for a phase transition is called a “critical state“. The autonomous agents in the system are assembled in such a way that the actions of one trigger the actions of another until the whole system changes radically.  This process occurs in a stock market crash, as Mr. Rickards explains:

• Buy and sell orders hit the market all the time just like snowflakes in the mountain. Sometimes the buyers and sellers are arranged in highly unusual ways so that one sell order triggers a few others, which are then reported by the exchange, triggering even more sell orders by nervous investors. Soon the cascade gets out of control,…The process feeds on itself…..Once the cascade stops, the complex system can return to a stable, noncritical state – until the next time.

The good news is that the catastrophe cannot be bigger than the system in which it occurs. For example,

• an active volcano on a remote island can make up a complex dynamic system in a critical state….Finally the volcano completely explodes and the island sinks, leaving nothing behind. The event would be extreme, but limited by the scale of the system – one island.

This brings us to relationship between Scale and Catastrophe Risk.  This is extremely important in financial markets, because thanks to massive liquidity injections by the world’s Central Banks, the size of the Global Financial System keeps getting bigger and bigger.
 

Scale & Catastrophe Risk – Mother Nature Knows Best

The relationship between catastrophe risk and scale is exponential. Mr. Rickards explains:

• This means that if size of a system is doubled, the risk does not merely double – it increases by a factor of 10. If the system size is doubled again, risk increases by a factor of hundred. Double it again and risk increases by a factor of thousand, and so forth.

Mother Nature knows this and handles this well.

• When a natural system reaches the point of criticality and collapses through a phase transition, it goes through a simplification process that results in greatly reduced systemic scale, which also reduces the risk of another megaevent.

Central Bankers & Governments – Do they know more than Mother Nature?

One obvious solution to the problem of risk is to make the system smaller, which is called descaling.

• This is why a mountain ski patrol throws dynamite on unstable slopes before skiing starts for the day. It is reducing avalanche danger by descaling, or simplifying, the snow mass.

But, Mr. Rickards says, the opposite is happening in global finance today.

• The financial ski patrol of central bankers is shoveling more snow onto the mountain. The financial system is now larger and more concentrated than immediately prior to the beginning of the market collapse in 2007.

The problem today is global.

• Europe’s sovereign borrowers and banks are in worse shape than those in America…Even China, which has enjoyed relatively strong growth and large trade surpluses in recent years, has an overleveraged banking system run by provincial authorities, a massively expanding money supply and a housing bubble that can burst any moment. 

The central theme of Jim Rickards is the post-2010 world and the crisis it might throw up.

• The post-2010 world may be different in many ways from the 1920s and the 1970s, but the massive overhang of unpayable, unsustainable debt is producing the same dynamic of deleveraging and deflation by the private sector offset by efforts at inflation and devaluation by governments. The fact that these policies of inflation and devaluation have led to economic debacles in the past does not stop them from being tried again.

What does Mr. Rickards predict?

• Next time, however, it really will be different. based on theoretical scaling metrics, the next collapse will not be stopped by governments, because it will be larger than governments. The five-meter seawall will face the ten-meter tsunami and the wall will fall. 

This is happening today with smaller governments. Greece is utterly helpless. A much larger Italy is being shut out by financial markets. This problem is still considered manageable because  of the combined resources of Germany and France.  Ultimately, this problem is not catastrophic because the U.S. Financial System is in a stable condition.

What would be a true catastrophe? A meltdown in the U.S. Dollar and the crash of the global financial system.  This is why Jim Rickards said the following in his interview* on Bloomberg Television on Thursday, November 10:

• The problem with
  the Fed is they think they are toying with the thermostat, hold the
  money supply up, if it gets too hot, dial it down a bit. It is not a thermostat. It is a nuclear reactor with fuel rods and control rods. You can dial it up and down but if you get it wrong, you have a catastrophe. Not that the house is too hot, but the whole thing melts down.

* See clip 4 of our article Interesting Videoclips of the Week (November 7 – November 11, 2011).

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