Friday, February 14, 2014

Certainty, Complex Systems, and Unintended Consequences

When it comes to complex systems and unintended consequences, the key phrase is "be careful what you wish for."

A lot of people are remarkably certain that their understanding of how systems will respond in the future is correct. Alan Greenspan was certain there was no housing bubble in 2007, for example (or he did a great job acting certain). There is no shortage of people who are certain the U.S. dollar is doomed to collapse, but only after losing the reserve currency status.

Other people are certain China can launch a gold-backed currency that will replace the dollar as the world's reserve currency.

Some are certain the U.S. stock market is going to crash this year, while others are equally certain that stocks will continue lofting higher on central bank tailwinds.

Being wrong about the way systems responded in the past doesn't seem to deter people from being certain about the future. Those who were certain there was no bubble in 2007-8 were wrong, and those (myself included) who saw the can being kicked down the road were wrong in not anticipating that global stocks would not just recover their pre-crash heights but go on to new nominal highs, based on the excellence of the can-kicking skills of central states and banks.

Complex systems don't act in the linear way our minds tend to work. Humans are built to distill a chaotic array of sensory data into a narrative that simplifies decision-making and risk assessment (for example, "us good, them bad"). We prefer our chains of causality to have a few big links we can follow without difficulty. We find systems with multitudes of ambiguous inputs tiresome and so we invent ideologies ("us good, them bad") and very occasionally, elegant mathematical statements that reduce the chaos of data to predictable causal chains.

We are built to cling very stubbornly to certainty once we reach a conclusion, because ambiguity and having to constantly change our assessments of inputs and causality are big drains on our energy and mental capabilities. It's "cheaper" in terms of energy and anxiety to just stick with the story we grew up with or the one we chose after a bit of looking at what our mates think/believe/claim is true.

Certainty has another advantage: it's more persuasive than hedged hesitancy.Leadership tends to fall to those without hesitation, the bold ones with the powerful rhetoric of certainty, confidence and optimism. We don't want the narrative muddled with hedges--maybe "them" are not necessarily evil, dangerous enemies, etc.--and so we shout down, ridicule or ignore those who are circumspect about how systems will respond in the future.

Politicians have of course mastered the art of distilling narratives to the desired state of certainty, confidence and optimism, and in repeating the story often enough that mere repetition lends it credence.

The problem is simplistic, linear narratives don't map complex systems. All sorts of unexpected and unintended things happen in complex systems when you change the inputs and try to control the output.

We have a name for systems where the inputs are all tightly controlled to yield a simplistic desired output: they're called monocultures, and monocultures are exquisitely vulnerable to unintended consequences and "leaks" from the outside world. Though monocultures look robust, they are actually quite fragile, because the natural feedbacks and redundancies of natural systems have been eradicated to make the desired yield the primary output.

This is why politicians cannot deal with either complex systems or unintended consequences. As a result, they have to act as if complex systems and unintended consequences don't exist.

Thus Federal Reserve Chair Janet Yellen sticks to the simplistic narrative that the economy is flourishing and so the Fed can "taper" its money-creation/asset-buying operation, but she is careful not to mention the unintended consequences of the Fed's monoculture: to mention just one, that since the Federal deficits are shrinking rapidly, if the Fed didn't reduce its $1 trillion a year program, it would soon end up owning the entire Treasury market.

Since there could be unintended consequences of that, the Fed chair doesn't mention the topic.

The narrative that printing money destroys the currency being printed is appealing on many levels. It makes sense, and history is replete with examples of just this narrative.

But the system isn't quite as linear as we might wish. If $10 trillion in dollar-denominated value is wiped out in write-downs triggered by marking phantom assets to market, and $1 trillion is printed, the system still lost $9 trillion. As correspondent David C. observed:

Destruction of dollar *value* means that surviving dollars become more *valuable.*

If stocks, bond, real estate, Beanie Babies, etc. decline in VALUE, it means they are worth fewer dollars-per-unit. This means that dollars are, by definition, rising in value per unit, and this absolutely confounds those who believe the next big thing is inflation/hyperinflation.

They simply can't see that if people become poorer (as their stocks, bonds, homes, etc. fall in value), and especially if the banks begin to fail in a wave too large to bail and take deposits into monetary nothingness, the most likely outcome is that those who retain access to dollars will see their dollars rises dramatically in purchasing power, the exact opposite of the last 82 years of experience.

I've encountered few people who can accept this paradoxical analysis.

Our fully fiat-money system enabled the embrace of illusions so pervasive that people simply can't see how much "value" today rests on cross-linked IOU's. When those IOU-dollars begin to evaporate in earnest, desperation for the underlying "asset" (a dollar, as perverse as that seems given that the dollar is backed by nothing and preceded by no production of value) should skyrocket."

As for China launching a gold-backed currency that acts as the reserve currency--it isn't quite as simple and tidy as it appears. Triffin's Paradox is based on a peculiar characteristic of a reserve currency: it serves both a domestic market and a global market, and the two have different dynamics.

A reserve currency must be available in size in global markets, which means the issuing nation must export its currency in size so others have enough of it to fill their reserves and grease their trade exchanges. The issuing nation can simply helicopter drop the equivalent of several trillion dollars of currency into other nations (something that hasn't been tried), or it has to run trade deficits, i.e. it buys more goods and services from other nations than it exports to them, and so it exports its currency to other nations to use as a reserve currency.

This means nations that run enormous trade surpluses can't issue a reserve currency, because they're not exporting currency, they're importing other nations' currency and having to "sterilize" it into their own domestic economy or buy something denominated in the imported currency.

There's another paradox. Let's say China became a net importer on a grand enough scale to issue a reserve currency. The one example we have of a nation issuing gold-backed currency that was also the reserve currency based on that nation running large trade deficits is the U.S. in the late 1960s. What happens in this circumstance is those holding the gold-backed currency decide to trade the currency for gold, and the issuing nation soon runs out of gold.

This sets up a paradox: net exporting nations cannot issue a reserve currency, fiat or gold-backed, for the simple reason they are importing currency, not exporting it for others to use as a reserve currency.

Any nation that does run a trade deficit large enough to enable a reserve currency and backs that currency with gold will see its gold reserves vanish as holders of their currency trade its currency for gold.

I have addressed a few of the complexities of reserve currencies and trade before:

The Impossibility of China Issuing a Reserve Currency (October 14, 2013)

Why the Shrinking Trade Deficit Will Choke U.S. Corporate Profits (August 8, 2013)

Understanding the "Exorbitant Privilege" of the U.S. Dollar (November 19, 2012)

When it comes to complex systems and unintended consequences, the key phrase is "be careful what you wish for." 

The Nearly Free University and The Emerging Economy:
The Revolution in Higher Education

Reconnecting higher education, livelihoods and the economyWith the soaring cost of higher education, has the value a college degree been turned upside down? College tuition and fees are up 1000% since 1980. Half of all recent college graduates are jobless or underemployed, revealing a deep disconnect between higher education and the job market.

It is no surprise everyone is asking: Where is the return on investment? Is the assumption that higher education returns greater prosperity no longer true? And if this is the case, how does this impact you, your children and grandchildren?

go to Kindle edition
We must thoroughly understand the twin revolutions now fundamentally changing our world: The true cost of higher education and an economy that seems to re-shape itself minute to minute.

The Nearly Free University and the Emerging Economy clearly describes the underlying dynamics at work - and, more importantly, lays out a new low-cost model for higher education: how digital technology is enabling a revolution in higher education that dramatically lowers costs while expanding the opportunities for students of all ages.

The Nearly Free University and the Emerging Economy provides clarity and optimism in a period of the greatest change our educational systems and society have seen, and offers everyone the tools needed to prosper in the Emerging Economy.

Read Chapter 1/Table of Contents

print ($20)       Kindle ($9.95) 

Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify. We will cover the five core reasons why things are falling apart:

go to print edition1. Debt and financialization
2. Crony capitalism
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Once we accept responsibility, we become powerful.

Read the Introduction/Table of Contents

Kindle: $9.95       print: $24 

Thank you, Lynn M. ($75), for yet another stupendously generous contribution to this site -- I am greatly honored by your steadfast support and readership. Thank you, Karl L. ($50), for yet another outstandingly generous contribution to this site -- I am greatly honored by your steadfast support and readership.

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