Essentially, what Watts (what? Only three wots? That’s not very bright!) should be arguing is that the global financial system got to the point where:

• It is self-sustaining and self-replicating.
• Self-referential and circular functions had become undetectable and unmeasurable.
• Responses of the system to external stimuli were becoming increasingly chaotic as a result.

Then it is not a case of individual companies being “too big to fail”. That is a political crock, reasoned to justify governmental intervention of a particular kind and for equally political purposes. At the political level, that kind of intervention can be justified provided that the rationale is honest – it is for political reasons that A is too big to fail. The cause of the failure might well be unforeseen circumstances arising from the global financial system. That is accepted. That is not the reason for the intervention; that is political, whoever does it.

Intervention, at its best, can do no more than try to hold the system in its current form of “equilibrium” whatever that might be. Any action that might disturb that equilibrium runs the risk of the global system going haywire or imploding. No one can point at any part of the global financial system as say “There is the initial cause – the tree that fell on the powerline”, as Watts has pointed out. However, his attempt at divining the cause to Lehmans’ door is as correct and effective as blaming the Pharoahs.

What must be considered here is that if the US government allowed Lehmans (or any of the other “too big to fail” financial companies) to fail (and similarly in Britain, in Japan, in Europe) then the consequential catastrophic failure of the global financial system would have been laid squarely (and fairly) at the respective government’s doorstep. To not recognise that as a primary political motive is shortsighted and just plain wrong. If the catastrophic failure had occurred (as it may still) the outcome for the likes of the US and other western nations would be bleak indeed. The main beneficiaries would be those economies with little to lose and the resources to take charge – led by China and India, perhaps Russia and South Africa if they could get their political houses in order.

The second consideration is that China currently owns some USD4 trillion of the US in the form of US Government Bonds. Add to that the likely indirect investment in the US private sector (by investment in banks that have on-lent the funds) and a very large part of the US is “owned” by (mortgaged to) China. And it must be said that the current Administration would be responsible for only a small part of that debt. The best part of it has gone up in smoke (literally) “in defence of freedom and the American Way” in Iraq and Afghanistan.

So, to all those who want to criticise their governments for their actions and reactions to prevent the potential collapse of the global financial system I want to propose the following –

1. If the present system is allowed to collapse, then there has to be some way of rebuilding it with the safeguards that are missing from the present system. As there has been very little in the way of commentary on what form it may take, it is useless to try and impose this or that political outlook on the future.
2. If the present system is allowed to collapse, the “owners” of the new system are likely to be those who have the resources – natural and/or economic – that will give them the power to control the system. As I have said, that could well lead to the present “masters” being overturned with totally unpredictable results.
3. The difficulty with the present system stems from size, rather than individual elements. I have posted on that aspect previously, and it requires no repeating here. It is the comprehension of the size that is the problem.

In the first episode I compared the global financial system with a Persian Carpet.
We can see the pattern, the inter-relationships, made by the thousands of individual tufts. We can even estimate the total number of tufts that there might be in the whole carpet.

But what happens if we examine one tuft. Enlarge it many many times – holy Mandelbrot!! It looks almost like the original carpet! This time around though, instead of looking at the whole carpet we have a small group – perhaps a nation, a city, perhaps a commodity market, perhaps an international company. It interacts with neighbouring tufts, with the “tufts” from which it is made, and via the carpet backing with other more distant tufts.

Now, repeat the same exercise. This time instead of organisations as the basis, consider the idea of information. The Persian carpet is the “summary” of the global financial markets. Think of it as a financial report. The individual tuft is the financial report set of an individual organisation. It presents information that is based upon a large number of individual transactions. Each of the threads within that tuft could be a category of income or expense, or transactions with another tuft. One has to know the rules for the tuft (how it works, what it contains) before it makes sense. In the context of the total carpet that tuft means very little. Removal of the tuft does change the carpet, it diminishes it.

Now, if you want to chage the pattern of that carpet, where do you start? Which tuft is the first to be moved, or removed? If you come across a tuft that is particularly worn, how do you go about replacing it so that the pattern is maintained, the integrity of the carpet remains?

Financial complexities... 3

The third factor that I want to introduce here is that of “self-referential” systems. Now this is something that is very easy to illustrate. It happens to anyone who uses complex or extensive spreadsheets. All of a sudden things come to a grinding halt with the succinct little message that you have created a “circular reference”; a formula is dependant apon a formula that depends upon… the answer of the formula it is trying to calculate. Now spreadsheets can not continue as long as that circular reference exists. It can not work round it. It stays stopped until the circle is broken.

But the truly complex system, such as the financial system that Watts is discussing, can depend upon such circular, self-referential, relationships. Note, please, this differs from feedback. It is the system itself changing and modifying as its complexity increases. The development of the whole derivatives market was impossible 100 years ago except in very small markets. It is the increasing speed and complexity of global communication (another factor that Watts refers to but does not develop) that has allowed the derivative products market to reach the importance and the instability that has led to the current crisis.

So, that is how close Watts got himself to third, to a three base hit. He was within a fingernail of success.

The homer in this is in a quite different direction. It comes from a tv programme, a news excerpt I think that led to a “re-enacted instance” involving the purchase of a car.

Essentially, when you are choosing between two or more alternatives there is a limit to the amount of relevant information the brain can use to make the decision. There are any number of systems and research ideas into how that limit can be overcome; ranging from processes to determine the most important factors in the choice to ranking each alternative between chosen factors.

That limit, given that no “artificial aids” are used, cuts in at four factors and removes any reasoned decision at six factors. So, in the car example a person provided with the full technical specs of two cars will revert to “four door wagon manual and I like the look” or “I prefer Toyota” rather than a reasoned analysis of make and model, engine capacity, safety, fuel consumption, drivetrain, wheel/tire size, acceleration, and all of the other information provided.

So, in making an investment decision it is far more likely that the investor will look at a small range of data, will close the paper, and run with what his brain tells him “feels right”. Even given full information, it is likely that the decision will not be fully rational.

This is being borne out time after time in the past two years by people who have invested in Finance Houses at the sharp (high-risk) end of the market with the same confidence as they might invest their money in a bank at less than half the offered return. “Safe as houses!”

And they were wrong. And so were their Financial Advisers. And so were the salesmen of the products being offered. And it goes on down the line as has been proven by so many in the past two years including Watt.

But no one has asked the question “Why were they wrong?” There are many who were looking no further forward than the next commission check, to be sure! There were many who just believed, without question, what they had been told. A large number would have been taken in by (what I know as) “The Brightest Men in the Room Syndrome” (TBMRS).

Even TBMR would have been operating close to the “six level” – choosing out of those six the factors that best suited their sale and which (they thought) were the strongest reasons.

It is important to note here that this leaves out intentional dishonesty. We are talking of the mythical “reasonable man” here and not the snake-oil charlatan (of which, incidentally there seems to have been far too many). But that is how TBMRS works as Enron proved.

To return to the point, Watts is correct in that the complex system is at fault. For any of the reasons he has given, and for the few others I have run through here. As he concludes –

Government regulators telling firms they can't grow or innovate sounds like dangerous meddling in free markets. But there are at least three reasons to think that it is reasonable.

First, there is already a precedent for precisely this kind of government intervention - namely anti-trust law, which effectively guards against firms growing so large that they stifle competition. Perhaps what we need is an "anti-systemic risk" law that would aim to avert systemic risk before it is too late. No doubt firms that are denied the right to grow under this law would complain; but firms complain about anti-trust rules as well, and somehow our free market system has survived, in part because the beneficiaries of anti-trust rulings are often smaller and more innovative.

Second, the current crisis has demonstrated that markets do not automatically regulate systemic risk any more than they automatically guarantee competition. Pragmatically speaking, therefore, government intervention is required to prevent markets from destroying themselves, and the relevant question is what kind of intervention is effective: preventive management, or after-the-fact rescue.

Third, and most fundamentally, there is something badly wrong with the kind of free market that ends up at the mercy of a single firm. Failing to deal with systemic risk, in other words, creates a world that is not only uncertain, but also unjust, in that individual firms can generate immense profits by taking risks that everyone else ends up bearing as well. Taking free-market principles seriously, therefore, requires us to acknowledge that firms that are "too big to fail" are really too big to be permitted to exist.

And, I regret, that is a silly gism based upon at least two delusions. (Don’t you just LOVE Dodgson?).

Watts’ first conclusion is right, there is precedent for governmental intervention in markets.

His second is really the question he set out to answer, though I suspect that he and many others will have forgotten that. Further, it is in the nature of markets to develop in a manner that makes choice and determination more rather than less difficult. I give credit that he speaks of the markets “destroying themselves”.
The third is just wrong. Until the point is reached where one firm has total control of a market, there has to be equilibrium. That point of stability requires the composition of the market to act as individuals. Lehman was not in that position. Not one of the players within the international market was “too big to fail”. The system would have continued without Lehman had they (or any other individual component) been left to die.

To blame the downfall of the global financial system on one firm, such as Lehman, as he and so many others have done is nothing short of simplistic nonsense. Watts had the right line – the complexity of the system – and failed to follow it through. It was not one firm, nor was it one product such as loan derivatives or short selling.

The “culprit” is a system that has become so large and so complex that nobody can say that they “understand” or can “predict” its total operation and outcomes. The internal relationships are such that even small changes in one factor can lead to large swings in seeming totally unrelated outputs.

Because of that complexity, fault-finding and remedies are reduced to the same level as mediaeval medicine, “Take this and if it doesn’t kill you it might cure you. At best it will have no effect”.

Essentially, what Watts (what? Only three wots? That’s not very bright!) should be arguing is that the global financial system got to the point where:
• It is self-sustaining and self-replicating.
• Self-referential and circular functions had become undetectable and unmeasurable.
• Responses of the system to external stimuli were becoming increasingly chaotic as a result.

Then it is not a case of individual companies being “too big to fail”. That is a political crock, reasoned to justify governmental intervention of a particular kind and for equally political purposes. At the political level, that kind of intervention can be justified provided that the rationale is honest – it is for political reasons that A is too big to fail. The cause of the failure might well be unforeseen circumstances arising from the global financial system. That is accepted. That is not the reason for the intervention; that is political, whoever does it.

Trust in the Top

That is the headline over an op-ed in today's Sunday Star Times by Chris Cherry, "a UK academic and writer living here..." and his "warning concerning the liabilities of trusting politicians.

He bases his article on the (now quiescent) volcano of the British MP Expenses raruraru, warning that "it could never happen in NZ" is a very short-sighted excuse for accepting the word of any politician.

The regretful part is, that in the probligo's part of the world he is preaching not to the converted but the cynical voter who trusts no one standing for elected office.

If he needs this explained at all, Cherry should take as just a small example the National government's reshaping of the Education vote.

On 28 May, the Herald published what was obviously a rehash of a Ministerial (I almost typed "Menstrual" - Freudian that is) post-Budget press release from Anne Tolley -

Cash-strapped, the Government has pushed most of its new investment in education toward increasing brain power, rather than bricks and mortar capital expenditure.

Education Minister Anne Tolley said the Government was "strengthening the ladder of opportunity" by allocating $1.68 billion to improve front-line education over four years in today's budget.

The budget outlined $1.337b in new operational education spending over the next five years, more than four times the $340m in new capital spending.

Now don't that sound grand!

Among items "reprioritised":

* $54m, reducing the funding subsidy for hobby courses in adult community education;

* $20m, combining the Team Up and Te Mana information campaigns;

* $18m, reducing Education Ministry support function expenditure;

* $275m, keeping early childhood education adult-child ratios at current levels, rather than proceeding with a planned reduction;

* $55m, reductions in tertiary funding.

Labour could not fund these "even in the best economic times", Mrs Tolley said.

Education projects attracting Government money included:

* $80.1m more for day-to-day school operations;

* $36m to support literacy and numeracy;

* $16m to fight truancy;

* $34m to improve access of schools to high speed broadband;

* $59m to improve the education of disruptive students, and those with special needs and behavioral issues;

* $69.7m for improving access to early childhood education (ECE), by expanding 20 hours ECE to playcentres and kohanga reo, and removing the six-hour daily limit;

* $19.9m to extend the Te Kotahitanga programme, to focus on raising Maori students' achievement.

That is the broad outlay.

I want to tackle the first of those "re-prioritised" items, the "hobby courses in adult community education".

The Herald did too, on 29 May, with this -

Independent schools will receive their first Government funding injection in a decade the $35 million allowing them to keep their fees at a more affordable level for parents.

Executive director of the Independent Schools of New Zealand Deborah James said she was delighted with the announcement as private schools had been struggling with a "crippling capped funding regime for the past 10 years".

She felt it was important the Government had acknowledged that if it did not help them out, a number of private schools might have been forced to integrate, which would have ultimately lapped up a portion of state funding that could otherwise be diverted towards public schools.

"[Independent schools] bring a choice in education, not all schools suit all children so it's wonderful in a democracy that families can choose an education that best suits the needs of their child," Mrs James said.

Tony Sissons, headmaster of King's School, said the funding would greatly assist the school's parents as it would allow him to keep cost increases at a minimum.

"Independent schools bring the opportunity for choice and by maintaining fees at a lower rate it gives more people the opportunity for choice around the country," Mr Sissons said.

Now, we jump forward to Jun 7 -

Private schools are hiring debt collectors to chase unpaid fees as the recession bites.

Baycorp general manager Joe Nel said his agency had about 300 private and state schools on its books, slightly up on last year, with an average of $650 a debt.

Graeme Byers, managing director of Guardian Credit Service, is chasing about $40,000 worth of debt for 15 private schools on his books.

The debts range from a few hundred dollars for sports fees to $8000 for unpaid tuition fees.

Byers said the debtors were mainly "pretty honest people who have got themselves into problems".

But some are harder to find. "The people have gone over to Australia - they've actually skipped the country."

Lynda Reid, principal of St Cuthbert's College in Epsom, Auckland, said referring unpaid fees to debt collectors was "an absolute last resort."

"When we have exhausted every option, yes we do, like every other business, have to bring in a debt collector. We do it very reluctantly."

Ok, so some of the private schools' clients are not paying?

Reid said the school [St Cuthbert's] took the step only when parents had ended contact and ignored the school's requests to discuss the problem. In rare cases girls were asked to leave the school.

However, Reid said the school [still St Cuthbert's] introduced automatic payments as an option last year to ease the pressure of paying fees all at once. Fees at the school range from $13,408 to $15,900 a year.

I guess (fairly safely) that only those who can really afford to send their kids to a private school like St Cuth's (and that has a very high reputation) would commit themselves to a cost like that.

Let's jump forward now to Jun 20 - a month after the first of these articles appeared -

Like a covert network, adults converge on empty classrooms to extend themselves in all sorts of ways. When the kids roll in the next day, there's no trace of what's taken place.

They were at it at Mt Roskill Grammar and hundreds of other secondary schools this cold Wednesday night: learning Thai cuisine, dressmaking, car maintenance, touch typing, English as a second language, Mandarin Chinese and the art of texting.

The Government spin is that the rest of us are victims of some rort: "Taxpayers should not be funding hobby and recreational courses like twilight golf, radio singalong, pet homeopathy, Moroccan cooking and concrete mosaics," says Education Minister Anne Tolley.

Even night school co-ordinators concede that many courses are more social in nature than stepping stones to a job or a pay rise.

And so the Budget announcement slashing funding for school-based night classes by 80 per cent - from $16 million to $3.2 million - failed initially to spark community revolt. "All sectors of the economy are affected by the economic situation and tertiary education is no exception," Tolley told the adult and community education sector group, ACE Aotearoa.

Obviously, Tolley would not have added "and the poor rich buggers who send their daughters to St Cuth's".

That's the thing about night school. It caters for the spectrum of interests from the self-indulgence of children's party planning and Spanish classes to vocational courses such as accounting and touch typing. Even at mosaics, jewellery and floral art classes, the career-minded mingle with the purists.

Yes, an indulgence indeed.

But.

I return to the opening, the Curry article. He has missed the boat. It left about 25 or 30 years ago. Politicians in NZ are no different to those in UK, or Australia, Or the US. They have only one motive, and I don't need to spell it out once again.

Go back, check the numbers...

"Hobby" classes, reduction $54 million

Private schools subsidy, increase $35 million.

Trust politicians?

Never!

Financial complexities... 2

The point here is that the output from the systems that Watts is discussing is comparatively, deceptively, simple. It is intended to be so that users – the people who invest money in the system – can understand the levels of risk impinging their investment and the value their investments have earned. It is the Persian carpet that is hung on the wall. It is an agglomeration of pretty colours and an apparently organised pattern. Understanding the detail that lies behind it, the seed values, the process, is beyond the understanding of any person.

The output is prepared from the accumulation of detail into increasingly generalised categories,

- by people who “understand” what they are calculating,

- but can not necessarily grasp the enormity of the detail and risk that they are given as inputs

- by people who individually work to prepare summarised number descriptions of the detailed data for which they are responsible. (Whew!!)

No one can describe the output from these systems as “wrong”. They are not. They are a logical and systematic accumulation of the financial data of the business. They do not “fail” as a result of the incorrect process or interpretation of individual transactions, or even an individual category of transaction.

The difficulty, and Watts has touched this, is placing that output into the world-view of the larger system of many similar reports and how they might interact.

The delusion is, therefore, that an objective investor has little chance of accurately assessing either the “value” of his return, nor the level of risk that he is investing against.

Again, simplicity can be surprisingly complex.

The intent here is to introduce the principle of feedback. In the system proposed by Watt, there are innumerable feedback points. Again that is a point on which he has touched, primarily from the aspect of governmental review and control of the system.

If feedback is introduced to the system at the wrong point, or in the wrong fashion, then the resulting consequences will not be as planned or intended. That, in Watt’s example, is just what is happening.

That is the major line of criticism aimed at virtually every governmental attempt to minimise the (national, economic, political, individual, business... take your pick)impacts of the collapse of the global financial system.

The third factor that I want to introduce here is that of “self-referential” systems. Now this is something that is very easy to illustrate. It happens at least once to anyone who uses complex or extensive spreadsheets. (My favourite at work has over 65,000 formulas, some of them nested to three or four levels). All of a sudden things come to a grinding halt with the succinct little message that you have created a “circular reference”; the current formula is dependant apon a formula that depends upon… the answer of the formula it is trying to calculate. Now spreadsheets can not continue as long as that circular reference exists. It can not work round it. It stays stopped until the circle is broken.

But the truly complex system, such as the financial systems that Watts is discussing, can depend upon such circular, self-referential, relationships. Note, please, this differs from feedback. It includes the system itself changing and modifying as its complexity increases.

Those changes might internally created (evolved) to cope with or provide new opportunities. The development of the whole derivatives market was impossible 100 years ago except in very small markets. It is the increasing speed and complexity of global communication (another factor that Watts refers to but does not develop) that has allowed the derivative products market to reach the importance and the instability that has led to the current crisis.

They might also be imposed from without - environmental pressures requiring adaptations. The biggest and most obvious are government controls. The difficulty here is that if the control, the environmental influence is against the direction the systems is wanting to adapt then the result is a series of work-arounds, further evolutions which accept and ameliorate the impact of the changed environment.

So, that is how close Watts got himself to third, to a three base hit. He was within a fingernail of success.

Financial complexities... 1

ust occasionally my old mates at Arts and Letters turn out a truly thought-provoking link – such as this from Boston Globe with Duncan Watts suggesting that systems ( he uses as examples the power grid crises in 1996 in Oregon and 2003 in the Northeast states) can become over-complex for which he suggests the term “systemic risk”.

Over the past year we have experienced something similar in the financial system: a dramatic and unpredictable cascade of events that has produced the economic equivalent of a global blackout. As governments struggle to fix the crisis, experts have weighed in on the causes of the meltdown, from excess leverage, to lax oversight, to the way executives are paid.
Although these explanations can help account for how individual banks, insurers, and so on got themselves into trouble, they gloss over a larger question: how these institutions collectively managed to put trillions of dollars at risk without being detected. Ultimately, therefore, they fail to address the all-important issue of what can be done to avoid a repeat disaster.
Answering these questions properly requires us to grapple with what is called "systemic risk." Much like the power grid, the financial system is a series of complex, interlocking contingencies. And in such a system, the biggest risk of all - that the system as a whole might fail - is not related in any simple way to the risk profiles of its individual parts. Like a downed tree, the failure of one part of the system can trigger an unpredictable cascade that can propagate throughout the entire system.

There is no need to retrace the whole of his article though I do intend to return to his conclusions.

Overall, he has covered the bases fairly well, provided that you are happy with a two-base hit. The idea he has used is a propos and makes for an interesting read.

The “Out” call at third though comes because he has missed an extremely important factor; one which does not in any way contradict what he has said but in fact is an augmentation of the prim misses he has started with.

It starts with the “complex system”. Now I, and anyone else with half a brain knows what Watts is talking about here; essentially a system which has a large number of inter-related and inter-acting nodes, where many of the relationships and interactions are not clear or well defined.

Being an old-time computer-wallah, and I mean OLD, “systems” has a flavour to it which turns my brain to parallels from that kind of world. So, with your patience I will indulge.

“Complex” systems can be extremely simple. The complexity can come from a number of different factors.

The most critical of these must be the system “Output”. Many moons back I taught myself to write Q-Basic, a language used by a number of accounting systems as well as the general home-writer. One of the programs I wrote with it used a model from Scientific American. It was two fairly simple formulas of two factors and a geometric (if I remember rightly “atan”) function. By taking the “answers” to the first calculation and feeding those back to the formula it was possible to print to the screen (in colour eventually) a veritable Persian carpet. Given the same two seed values, the result was always the same – the same carpet was generated. By choosing a different pair of seed values though you could arrive at a totally different carpet, or nothing at all.

Now that original model came out of the first days of “chaos calculation” and re-iterative functions. Who remembers Mandelbrot, and fractals these days other than Wikipedia? It was used to illustrate that a reiterative function could, in time, bring results that varied hugely from the initial calculations and even from the immediately prior calculations.

The point here is that the output from the systems that Watts is discussing is comparatively, deceptively, simple. It is intended to be so that users – the people who invest money in the system – can understand the levels of risk impinging their investment and the value their investments have earned. It is the Persian carpet that is hung on the wall. It is an agglomeration of pretty colours and an apparently organised pattern. Understanding the detail that lies behind it, the seed values, the process, is beyond the understanding of any person. The output is prepared from the accumulation of detail into increasingly generalised categories, by people who “understand” what they are calculating, but can not necessarily grasp the enormity of the detail and risk that they are given as inputs by people who individually work to prepare summarised number descriptions of the detailed data for which they are responsible.