“WHY did nobody notice it?” after the 2008 credit crunch.
A few years after this we were sitting in a London cafe pondering a similar question. In fact, we were discussing a basic paradox in economics and finance. All the major schools of economic thought have an underlying premise that, over the long term, the forces of supply and demand reach an equilibrium and converge around a relatively stable middle point. In a similar way, the concept of “fair price”, where the value of an asset reaches a middle point at which a buyer and seller agree, is a cornerstone of finance theory. According to these theories, financial crises arise when the system deviates too far from the equilibrium or fair price. Detecting the emergence of a crisis should therefore be easy, since we need only to track the distance of key metrics from equilibrium. So why isn’t it?
History shows that economies and markets do not behave in quite the way that the theories predict. Just like evolutionary processes in the natural world, they experience periods of stability punctuated by periods of uncertainty and chaotic behaviour, which often emerge suddenly.
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We believe that we can provide the Queen with a clear answer to her question. If government agencies and financial institutions had appreciated that markets have much in common with living ecosystems, and so are driven by long-term evolutionary processes, then early warning mechanisms could have been in place to identify the anomalies that led to the financial crisis.
Let’s elaborate on this: traditional economic and financial analysis strives to explain economic events by rationalising the link between past events and the present, all under the constraints of a particular economic theory. Therefore, outputs from a typical analysis might read “markets went down as investors decided to cash in profits” or “bond yields grew following the latest Bank of England announcement”. These analyses tend to focus on one, or even several events, to explain the causal link between past and present in a deterministic manner.
In the context of the 2008 financial crises, traditional financial analysis pinpoints the market deregulation of the 1980s and 1990s as the primary cause of the crash. However, this is akin to saying that a person became diabetic because they consumed too much fast food over the past few years. While it might be correct to say that there is a link between diabetes and fast food, diabetes is the result of genetics as well as lifestyle. It builds up over an individual’s life, initially without betraying any symptoms of its existence.
In other words, it is not a simple matter of cause and effect, but a dynamic process that evolves slowly based on a pre-existing propensity to a disease that ultimately manifests itself in a relatively sudden manner. So, in both diabetes and financial crises, it is not just the detection of the phenomena that is important – this is usually too little, too late. Of greater importance is the understanding of the propensity for the phenomena to emerge. As mathematicianBenoît Mandelbrot said, in order to understand the fractal shapes in nature, “think not what you see, but what it took to produce what you see”.
We take this view in recent research in which we analyse an extensive range of historical business data from different industries and geographies (). We found that financial crises emerge not as the result of specific economic events or regulatory developments, but rather as a result of a long-term evolutionary process that regulates companies’ growth – mergers and acquisitions. Inevitably, this process leads to the emergence of imbalanced ecosystems – akin to oligopoly or monopoly – consisting of a few very large, but sluggish “too big to fail” entities, alongside very small, niche entities. So a few big companies keep on getting bigger but, on average, do not improve their performance. Here, we emphasise the importance of an ecosystems perspective: it is precisely due to the web of interdependencies among all companies that the unrestrained growth of one, or a few companies, leads to a systematic imbalance analogous to the unrestrained growth of cells we see in cancer.
The development of imbalance is seemingly ubiquitous, manifesting itself in the global financial crisis of 2008, the Japanese banking crisis of the 1990s, and was even present in the railway crisis in the UK in the early 1920s, which prompted the government to take over ownership under the 1921 Railways Act. This mechanism can be summarised in a simple form: the larger a company’s ancestry (the number of entities acquired which then form part of the company) the higher the likelihood that company will merge again, leading to a positive feedback loop. Returning to our analogy with diabetes, the ancestry mechanism is the genetic flaw in free markets that leads to the onset of a chronic condition.
“The genetic flaw in free markets leads to the onset of a chronic condition”
In earlier research, we developed a tool to evaluate the ecosystems of financial markets, which identified two mechanisms that act as catalysts for the emergence of a crisis. The first is banks copying the business models of the most (short-term) successful bank, which leads to loss of both diversity and resilience. The second is investors such as fund managers increasing their appetite for risk by trying to outperform competitors. In our view, those two items are to banks the equivalent of fast food and alcohol to a person on the verge of diabetes – factors that speed up and enhance the onset of disease.
Once we accept the view that, over a long-term evolutionary period, free markets have significant flaws that will eventually lead to crises, then this leads to a number of expected consequences. Instead of demanding “no more boom and bust” as the UK’s former prime minister Gordon Brown did, regulation should be focused on (a) slowing down the development of the ecosystem’s imbalance; and (b) mitigating the effects of such an imbalance. Therefore, the ideologically driven debate as to whether markets require more regulation or can regulate themselves, can be moved to a more productive principle: new regulation should be brought in only if it helps to maintain the overall diversity of the economic players in the system. A big concern for us is that most regulation introduced since the 2008 financial crises is actually reducing diversity, and therefore storing up even bigger problems for the future.
Tactical battles
It is important to emphasise that we believe economic theory and traditional finance have significant merits in their own right. We are not seeking to discredit those sciences, as has become fashionable recently, in favour of complexity and evolutionary science. The traditional theories work well, and are useful for evaluating market fluctuations within a limited time window in both stable and volatile periods. However, they are not the correct framework to pick up long-term trends and periods of transition such as the emergence of a crisis and the subsequent return to stability. In these cases, we believe that an evolutionary approach is more appropriate. The two frameworks are complementary. Traditional economics and finance theory can help us to win the tactical day-to-day battles, whereas complexity and evolutionary science helps us to understand the direction and risks we are facing from a strategic point of view.
We are working with analysts and traders from several global institutions, exploring this new “business ecosystems” approach, to develop “smarter” risk management and strategic analysis methods.
The evidence that evolutionary processes govern the commercial world is clear to see. The London cafe where we had our meeting, for instance, is surrounded by majestic buildings that once served as offices and warehouses for the major corporations of the industrial revolution. Today they are cafes and hotels. Things have evolved. And now it’s time to develop new ways to analyse the commercial world based on the rules we observe in nature.
This article appeared in print under the headline “The Wall Street jungle, deconstructed”
