Ecology of Finance

Universe in 2009 / by Benjamin Phelan /

A growing cadre of biologists argues that ecosystem analysis of the world economy might stave off a repeat of 2008's financial catastrophe.

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When Alan Greenspan appeared before Congress in October, he took some kicks for his failure to foresee the near total collapse of US credit markets. That was largely why he was there — public punishment, hands and feet locked in stocks in the town square. But committee chair Henry Waxman went further than that, interrogating Greenspan’s worldview itself. Greenspan had been advised, Waxman said, “to prevent [the] irresponsible lending practices that led to the subprime mortgage crisis.” He asked the former chair of the Federal Reserve, “Do you feel that your ideology pushed you to make decisions that you wish you had not made?” In other words, he all but asked, had ideology warped and bewitched his intellect?

Waxman was espousing a suspicious view of the nature of ideologies, which Greenspan refuted: “Everyone has [one],” he told Waxman. “You have to — to exist, you need an ideology.” World markets are too intricately interconnected and money transfers too voluminous and rapid for even an eminence such as Alan Greenspan to apprehend directly. Global finance is nebulous and ever shifting, but there are laws that govern its behavior. One needs an ideology to formulate those laws — or, in the language of science, a model to reduce the problem’s dimensionality. Free-market capitalism is, in Greenspan’s view, the best model yet employed by humankind. Its core principle can be summed up in this way: Largely unregulated competition leads inevitably to the best of all possible worlds.

Even free-marketeers like Greenspan now recognize that unregulated capitalism has serious, perhaps fatal, weaknesses, and is in need of a tune-up. The world could try to develop a new model from first principles, but Princeton’s Simon Levin, the Scripps Institute’s George Sugihara, and Oxford’s Bob May have published work pointing out that there are many natural systems that mimic, in nontrivial ways, the functioning of financial markets. “I’ve come to understand,” says Levin, “that they’re the same kinds of systems.” Both feature competition for limited resources; individuals trying to maximize their own return; and competition and exploitation as well as the need for cooperation.

Moreover, Levin and his colleagues argued in a 2006 report for the National Academies of Science and again in a 2008 commentary in Nature that the long history of natural systems is strong evidence of those systems’ resilience against major shocks. For instance, some features, such as predator-prey ratios, have remained stable over hundreds of millions of years. The challenge is to engineer financial markets that are similarly robust.

Levin is hesitant to appropriate any model, in toto, from one system and indiscriminately apply it to another; an ecology and an economy will never be perfectly analogous. Rather, he says, researchers should try to find the shared principles that govern the behavior of each.

Economies and ecosystems are what Levin calls complex adaptive systems, ones, he says, “that are made up of lots of individual agents that act together in smaller scales.” The collective consequences of those actions exhibit the hallmark features of complexity. A key feature of complex adap tive systems is that they can settle into a number of stable equilibria: The tech bubble of the 1990s was one such state, but so was the Great Depression. Similarly, in ecosystems, it is natural for species to go extinct; so too is it for corporations.

The phenomenon of contagion is equally relevant to both systems: A disease sweeping through a city follows a trajectory similar to that of panic through a financial market. Without proper quarantining by public health officials, an outbreak of measles can turn into an epidemic; without decoupling some aspects of financial systems from one another, a downturn in one sector can spread to others and trigger a run on the banks. “Certain things in economies and in nature are limited to the topology of the network of interaction,” says Levin. “You can build in what amounts to firebreaks. How you would limit epidemic spread” — or financial panic — “depends on the topology of the interactions.”

This topology can be understood via a trophic web, an ecological tool that maps natural dynamics such as the energy transfer between predators and their prey. Its contours can be described by well-understood differential equations. In finance, a modified trophic web could be used to model the dispersal of anything of value through a given market. For example, economists have the tools to track the flow of money and identify critical players and links in the banking system by analyzing webs such as Fedwire, through which banks make electronic payments to one another. Correctly modifying that web could help bankers and financial planners to design safety valves to quarantine whatever contagion (a shrinking credit market, a deflating currency, a nasty rumor) was threatening to fuel a panic. That would quell the panicked behavior before it could spread too widely and wreak unpredictable and irreversible damage — before it tipped the market from a desirable equilibrium into an undesirable one.

George Sugihara notes that the culture of most banking institutions is almost totally lacking in the broad approach that implementing such measures would require. “If you look at the amount of money,” he says, “that banks spend on single-firm risk analysis — does the Deutsche Bank have too many illiquid Scandinavian assets? Do we have too big an exposure on short-term government paper? — it’s huge.” But Sugihara says the cost of those risks, should those markets go south, is low. Generally, risk managers can mitigate such risks for relatively small amounts of money.

“But almost nothing is spent,” he continues, “on the more expensive problem of systemic risk, with large-scale markets collapsing. And that’s really an ecosystem problem.”

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