by Milo Clark
(Swans - September 12, 2005) How far are we lulled into self-induced torpor? Can we yet break loose?
One observation possible is that many systems have gone exponential. Can or will the accumulations of exponentialities assume critical mass? If so, what would result?
Models of randomness have coalesced into mindsets or models in which randomness is generally assumed to be predictable and linear, that is, essentially bell-shaped in distribution. Given such assumptions, randomness is ordered. Within the order assumed, random events are predictable in occurrence and in effect. The message is that they can be managed. If manageable, who is to manage?
The answer to that question may now exceed assumptions.
Does or can an unpredictable stabilize or destabilize a predictable? Given models of randomness assuming an essentially linear bell-shaped distribution, is an unpredictable actually unpredictable? Can or does a model or models of predictability affect the unpredictable?
Wittgenstein asked, "How can you teach a blind man red?" Bohr and Heisenberg told us how observers affect the observed.
If all systems are constantly in flux and interacting in multidimensional, multivariate ways, that is, changing in all dimensions, all directions, all aspects at all times however measured, how can a models such as essentially linear bell-shaped distributions reflect actuality much less anything? Obviously, given a moment's reflection, they cannot. Yet, it is the assumptive model now dominant in all but a few minds.
Benoit Mandelbrot, now in his 80s and hanging out at Yale of all places, is one of the few who question dominant assumptions. The few who recognize Mandelbrot's name usually associate him with fractals and chaos. He is difficult to classify, however, as his mind runs rampant across so many disciplines.
His forays into financial economics titillate. Mandelbrot is a mathematician of exceptional skills. For me, his greatest work lies in simple insights ranging far beyond the languages of numbers.
From systems perspectives, he swings Manjusri's double-edged sword in wide swaths hacking into unexamined assumptions. His primary value, as I see it, is asking "What if...?"
His latest effort, The (Mis)Behavior of Markets, A Fractal View of Risk, Ruin and Reward, rattles cages long overdue to be shook up. For me, the details are somewhat irrelevant and awash in complexities far beyond my ken. It is the asking which is key. The asking is very threatening to established perspectives reliant on essentially linear bell-shaped distribution curves.
At any given time presently, I understand that there are derivative contracts juggling over three trillion ten billion dollars in relative value. More are generated than completed. Derivative contracts have emerged into the last twenty-five years or so as a means to distribute risk.
As an investor or asset holder or producer dependent on any commodity or market situation, I can lay off the risks I perceive at relatively minimal current cost. In that sense, derivatives are options taken to their logical extreme.
Those who create and distribute derivative contracts are involved in a giant international financial safety net. Should the net itself be rent, consequences ripple and multiply in ways quickly beyond classification or quantification. "Oops, Ma, there went baby, bathtub and house."
Critical mass occurs when the relevant systems trigger each other into chaotic catastrophes. It can be a domino theory and all that sort of thing only all at once rather than sequentially. Domino Theory assumes that A triggers B, B triggers C, C triggers D and so on and so forth. Classical cause and effect in a straight line. A random actuality is that all fall in the same or near same instant. Whether dominos or houses of cards, down they tumble. Humpty Dumpty and all the King's men fail again.
Derivatives are only one of countless systems gone exponential. Advocates of globalization extol the interdependencies involved as a positive virtue. Almost any minimally complex physical product is composed of parts originating from multiple sources and assembled someplace else before introduction into distribution channels. Every part represents equally complex systems from design through engineering through development through choices of where and when and how much, all of which are expressed in various financial vehicles judged adequate within parameters of end-user acceptance in volumes adequate to support the systems involved. Any retail outlet in the world is clogged with nearly unimaginable quantities of products participating in dynamic systems.
Physical product manufacturing and assembly is laughingly simple compared to the complexities of international finance.
The assumption of essentially linear bell-shaped behavior assigns the vast bulk of events, possibilities and probabilities within parameters defined as plus or minus one standard deviation from norm. Outside those parameters, events are so unlikely as to be almost immeasurable. To quantify, assume that anything beyond one standard deviation has a probability of something less than 0.25.
Given the sheer volume of assumed actualities to occur, deviation outside one standard deviation is within acceptable risks and built into calculations involved. And that level, under that set of assumptions, risk can be spread or managed through pricing calculations or off-loaded through vehicles such as insurance, re- insurance and derivatives.
Much like Newtonian physics, it works most of the time. Will it work all of time? No. But we can handle that, right? Katrina is testing assumptions.
History is replete with challenges to such assumptions. We are familiar with situations, typically in retrospect, called "bubbles." If there is a real estate bubble in a county of a state and it bursts, some people, overextended, are hurt and others, more cautious and holding cash, benefit from bottom feeding. Bubbles can be very large and inflict greater hurt and benefit, of course. The nature of bubbles is assumed to be relatively specific, confined to certain market aspects and, with effort and spread of risk, manageable.
Recessions, depressions, crashes, and bankruptcies may stall the systems and create more extensive degrees of chaos but recovery is always expected. Time and survival takes care of whatever is needed. The events are ordered into packages and consigned to various files while recovering systems begin to work up to the next set of random events stretching the essentially linear bell-shaped world beyond one standard deviation yet one more time. When will they ever learn?
What if the Mandelbrot Set of currently operational systems beyond definitive measure goes critical? Outside the essentially linear bell-shaped assumptions, there exist other perspectives which will not obey those assumptions. Are we on the threshold or are we tripping in crossing it?
In a put and call option, risks are contained by the range between expected events. The most I can gain or lose is expressed in the contract. A put and call option assumes that the situation involved remains viable, operational. Can we assume that today's key systems are resilient, capable of being managed? Are they certainly within one standard deviation or within the tiny probability beyond?
Leopold Kohr, a social economist, wrote quite simply that all systems have their limits. Once exceeded, systems implode. The waves of mergers and acquisitions that have flooded over economies in the last fifty years have served to severely stress myriad industries.
Mergers and acquisitions have disappeared once proud brand names beyond recall. Successions of them have submerged layers of brand names from proud to common to forgotten. In near countless illustrations, Leopold Kohr has proven prescient. What if present accumulations and accretions now threaten the overall system? Guns and butter as a national strategy failed in the Vietnam years. Will guns and butter strategies work in the Iraqi context?
The American military has evolved into the mightiest of world history. Yet, in the larger wars of the last fifty years, all that might has stumbled now for a third time. The response after Korea and Vietnam was to rebuild an even stronger military now far beyond the capabilities of any nation-state to confront. Nation-states are quite unwilling to attempt confrontation therefore. The random event not assumed is that nation-states, to an enlarging degree, are less and less relevant.
Presently, having launched a war in assumption that might equals right without fail, a rickety nation-state was easily tumbled. That effort seems well within essentially linear bell-shaped assumptions. Yet, the essentially linear bell-shaped assumptions are now imploding. Insurgents with homemade bombs are challenging where nation-states tremble. They are not fighting fair!
The British Redcoats and Hessian mercenaries of the American Revolutionary War complained bitterly that the uppity colonists didn't fight fair. The British military doctrines of the time determined that foes would assume tight phalanx formations and advance forthwith on open fields.
Whenever revolutionary troops attempted such tactics, they did badly. However, when the revolutionary forces adopted Indian tactics, dispersed, shot from behind trees, hit and withdrew somewhat randomly, the British suffered both physical and psychological casualties. Eventually, they gave up.
Iraqi insurgents are poorly equipped, allegedly ragtag ragheads, unburdened with heavy armor, mobile and quite willing to accept casualties to bedevil the all-mighty American military. This system implosion is doing much more than bleeding a few soldiers, it is bleeding a nation in many ways. The financial burdens of a guns and butter strategy are cutting in.
Then comes Katrina. Is she the straw poised over the camel's back?
Many believe that protests were the major cause of American withdrawal from Vietnam. In parallel and little noticed by the public, the overt and covert costs to the American economy of the time triggered a near national bankruptcy evaded only by massive infusions of foreign funds, wrenching changes in overall financial structures and cover-ups which bedeviled American resources for many years.
With recovery finally stabilized by the 1990s, a new administration responds, it asserts, to a challenge by unleashing forces akin to those which destabilized the American economy in the late 1960s.
A major difference today is that the role and position of the American economy is even more vulnerable. The American systems are much more exposed. The American systems are much more interdependent within world systems. Foreign money now sustains the US Economy. The preponderance of that foreign money is now Asian, no longer European.
Any relatively minor change in willingness to invest in American securities has potential to bust out of essentially linear bell-shaped assumptions. Already, American assets are being bought at bottom feeding prices by foreign investors.
In a very multidimensional world, with myriad systems gone exponential, given the probability of events beyond one standard deviation, the risks of implosion may assume critical mass at any moment. Can this confluence of random events be managed? Time may tell assuming we have time.
And then came Katrina.
The (Mis)Behavior of Markets: A fractal view of risk, ruin and reward, Benoit Mandelbrot and Richard L. Hudson, Basic Books, NY, 2004, ISBN 0-465-04355-0
See also: London Review of Books, 4 August 2005 (p.21), for review of The (Mis)Behavior of Markets.