Yet Another Finger of Instability

Fingers of Instability
Ubiquity, Complexity Theory, and Sandpiles
Stability Leads to Instability
A Stable Disequilibrium
3 Billion and Counting
60 Years and Counting

To trace something unknown back to something known is alleviating, soothing, gratifying and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the first instinct is to eliminate these distressing states. First principle: any explanation is better than none... The cause-creating drive is thus conditioned and excited by the feeling of fear ... Friedrich Nietzsche

This weekend I turn 60 and have been a little more introspective than usual. I am often told that the letter I wrote well over three years ago on ubiquity and complexity theory and the future of the economy was the best letter I have ever done. I went back to read it, and it has aged well. I basically outlined how a financial crisis would unfold, and now it has.

On reflection, I think that there are perhaps other, even larger, events in our future than the recent credit crisis and recession; yet, just as in 2006, there is a great deal of complacency. But as we will see, there are fingers of instability building up that have the potential to create large disruptions, both positive and negative, in our future. And for the political junkies in the room, I offer a brief insight into what may be one of the more intriguing behind-the-scenes developments in recent years. Now, to the letter.

"Any explanation is better than none." - Nietzsche

And the simpler the explanation, it seems in the investment game, the better. "The markets went up because oil went down," we are told (except that when oil went up, then there was another reason for the movement of the markets). But we all intuitively know that things are far more complicated than that. However, as Nietzsche noted, dealing with the unknown can be disturbing, so we look for the simple explanation.

"Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain that make us feel good. We become literally addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important in achieving the chemical release. And thus we look for reasons.

The credit crisis happened because of Greenspan's monetary policy. Or maybe it was a collective mania. Or any number of things. Just as the proverbial butterfly flapping its wings in the Amazon triggers a storm in Europe, maybe an investor in St. Louis triggered the credit crisis. Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, tornados, and the movement of markets. Then we look at how the world and that investor in St. Louis are all tied together in a critical state. Of course, what state and how critical are the issues.

Ubiquity, Complexity Theory, and Sandpiles

We are going to start our explorations with excerpts from a very important book by Mark Buchanan, called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies.

As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic buckets and making sandpiles? Slowly pouring the sand into an ever bigger pile, until one side of the pile started an avalanche?

Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds on itself and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld, began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found that there is no typical number:

Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur.

The piles were indeed completely chaotic in their unpredictability. Now, let's read this next paragraph from Buchanan slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. (emphasis mine)

To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains.

Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth's crust, triggering earthquakes, or as wholesale changes in an ecosystem - or as a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third-rate paper in Denmark could cause worldwide riots?

Buchanan concludes in his opening chapter:

There are many subtleties and twists in the story ... but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds - atoms, molecules, species, people, and even ideas - have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before.

Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the likelihood of an avalanche becomes 2.14 times more likely. We find something similar with earthquakes. In terms of energy, the data indicate that earthquakes become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law," a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game?

... after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability.

Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

Now, let's couple this idea with a few other concepts. First, Nobel laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then, when the trend fails, the more dramatic the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior. (And, three years later, we can now all see that truth. But it was not as obvious to a lot of people in 2006.)

Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."

Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, giving a paradoxical rise to even more apparent stability. As the late Hunt Taylor wrote, in 2006:

Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.

... I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it.

A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

A Stable Disequilibrium

So we ended up in a critical state of what Paul McCulley called a "stable disequilibrium." We have players of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their own personal outcome and to reduce their exposure to "fingers of instability."

But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened: the historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.

The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

So, where are the fingers of instability today? Where are the fault lines that could trigger another crisis? Are there any early warning signs? I see two possibilities, one positive and one negative.

Chad Starliper sent me the following graph. It shows the debt-to-GDP ratio for the US, adding in various levels of debt. For instance, the ratio of debt to GDP for all levels of government debt is 87%. But if you add household and business debt along with the GSE (government-sponsored enterprises) like Fannie (FNM) and Freddie (FRE), the ratio rises to 331%. If you add in future benefits of Social Security and Medicare, the number becomes more like 1,000%.

The Obama administration tells us that the government deficit is going to be well over $1 trillion a year for at least ten years. And that does not take into account the outlier years in the 2020s when the really heavy lifting of Social Security and Medicare kicks in.

There is a truism that goes a little like, "If something can't happen, then it won't." Let me make a prediction. We won't have a trillion-dollar deficit in ten years. Why? Because it can't happen. The market will simply not allow it.

As I have written, we can run large deficits almost forever, as long as the deficits are less than nominal GDP. While it may not be the wise thing to do, it does not bring down the system.

But when you start adding to the deficit in amounts significantly larger than nominal GDP, there is a limit. Each dollar, like the grains of sand, adds to the potential instability of the system. Is it $2 trillion more? $3 trillion? No one can know, but the longer it goes, the worse the ensuing financial earthquake will be.

The current political class and their intentions are dangerously close to killing the golden goose. It is one thing to steal the eggs; it is an altogether different thing to kill the goose through ignorance of the consequences. And the size of the deficit, for as long as they plan to have it, will most assuredly kill the goose.

Just as I was writing in 2006 about the potential for a crisis, and yet the party went on for quite some time, I think the party can limp along now. But there will come a point when the party is over. Interest rates on the long end will rise precipitously, forcing mortgages up and making the deficit even worse. It will be an even worse crisis than the one we have just gone through. And there will be fewer options for policy makers, and none of them will be good or pleasant. And it will take most people unawares. They will see the current trend and project it into the future. And they will be hit hard.

Can we avoid this calamity? Yes, we can wrestle the US budget deficit back under some kind of control, close to nominal GDP or on a clear trajectory to get there within a reasonable time (say, a few years). As noted above, we can run deficits close to nominal GDP almost forever. But there is no political willpower to do that now. And so, the market will at some point force the hand of the political class. That investor in St. Louis, or China or (????) will decide not to buy government debt at such low rates. The avalanche will start. And everyone will be surprised at the ferocity of the crisis. Except you, gentle reader. You have been warned.

Let me re-emphasize that point. If we do not get our act together, the results could be truly serious. And it is not just the US. Japan, as I have written, unless it changes, will hit the wall in the next few years. There are some really sick actors in Europe. You are going to have to be far more nimble and prepared for this next crisis, should it arise, than you were for the last one. Over the next few months, I will be devoting some space to helping us think through how we do that.

3 Billion and Counting

And now for something a little more positive. From the beginning of the wireless revolution and the development of the internet, it was not until 2001 that we finally had one billion people connected. It only took another six years to add another billion. And sometime in 2011, somewhere in the world, we will add yet another billion. We are adding some 70,000 people a day, with smarter and cheaper computers, phones, and netbooks. By some estimates, there will be five billion connected to the network by 2015.

A study done in 2005 of 21 developing countries by Leonard Waverman of the London Business School

... showed that an extra 10 mobile phones per 100 people in a typical developing country leads to an additional 0.59% of growth in GDP per person. (Jump Point)

Think of each one of those additional connected people as a grain of sand. We have already seen a large surge in productivity from the internet and mobile phones. Farmers in India now know what the prices are for their products and don't have to take lowball offers from middlemen. Fishermen in Indonesia can call around and find where they can get the best price for their day's catch.

Tom Hayes argues in his book Jump Point that, because of the growing connectivity, rather large changes are coming to the way we organize our lives. It is a very interesting book and one that I will review in depth at some point.

But what Hayes calls the Jump Point is what I referred to as critical mass:

In mathematics it is called a 'jump discontinuity.' In engineering, this is known as a 'step phase change.' In climatology, it is called an 'abrupt delta.'

I call it a Jump Point - a change in the environment, in this case the business environment, so startling that we have no choice but to regroup and rethink the future. (from the introduction)

Not all of the changes are benign. The potential for business and marketing models to be turned on their head is rather striking. I recommend the book to those who are thinking about the future. It is easy to read, provocative, and well written.

I wrote this three years ago:

Today more than ever your portfolio should be targeting absolute return strategies. In a world with fingers of instability that may be connected in ways we have not seen in the past, caution is the order of the day. If we do see a slowing US economy later this year, the average complacent investor is not going to be happy as his diversified portfolio all seems to be going south at the same time.

That is still true today.

60 Years and Counting

I turn 60 on Sunday, although we will be celebrating with parties on Friday and Saturday. For whatever reason, when I turned 50 I was apprehensive. I can quite honestly say that I am excited about this birthday, and the future. For all the problems we are facing as a country and as a world linked together, I think this is the most exciting time to be alive in the history of the world. And the next 30 years are going to be much better than the last 60!

And you, gentle reader, are part of my reason to be so optimistic about the future. I continue to be amazed that so many people find the writings of this humble analyst to be worth their time. In truth, we are all constantly bombarded with more and more emails, advertisements, phone calls, letters, books, papers, and information, and it is getting harder and harder to focus on what is really critical. You give me the most important gift that anyone can receive in the Information Age, and that is the gift of your attention. You have hundreds of opportunities to divert it elsewhere, and yet you give me some of your precious time. I am grateful, and will always strive to make this letter worthy of your interest.

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

Communications from InvestorsInsight are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors and other contributors do not necessarily reflect the opinions of InvestorsInsight, and should not be construed as an endorsement by InvestorsInsight, either expressed or implied. InvestorsInsight is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided "AS IS" without any warranty of any kind. Past results are not indicative of future results.

Comments

[Leftfield:]

Happy birthday!
`I will suggest that the incentives are clearly warped towards the bloated financial engineering, cronies and political hack sectors of the economy to continue to contribute to the unstable areas where avalanches have occurred. Life has been good for them and they wield disproportionate clout to drag the rest of us in. These Wall St.-induced instabilities have gone on repeatedly, ever-larger, since the Latin American debt crisis, early 80's.
A healthy economy would more resemble a stable sandpile where the areas that have a need of buildup are supplied by entrepreneurs seeing an opportunity. This builds up the pile of wealth sustainably in total in the society (general prosperity). Introduce political coercion, and you have a pile that cannot grow as large, but has unequally built-up areas which are unstable. The selfish beneficiaries gain undue clout and force society to contribute to those areas while the overall pile shrinks.

Oct 04 07:57 AM

[Roger Knights:]

Wonderful. The key point is that one can't make an apples-to-apples comparison with similar-seeming situations in the past, because too much of what happens is acausal / chaotic. One can't quantify the fragility of a system or predict which straw will break the camel's back (to use another analogy). Therefore one should be always sensitive to hidden spots of rot in the structure, because they could cause a domino-like collapse if a shock occurred. Thus, looking back, statistics-citing (quantitative) optimists who point to times in the past when the sandpile was steeper and pooh-pooh concerns by saying, "There's a lot of 'ruin' in a country" should not lead one into complacency. (This is Taleb's message too--quantification of risk is misleading, because it doesn't capture enough of reality.)

Oct 04 08:42 AM

[H. T. Love:]

Happy birthday!

A truly fascinating and informative article. Thank you.

"And now for something a little more positive. <snip>
... We are adding some 70,000 people a day, with smarter and cheaper computers, phones, and netbooks. By some estimates, there will be five billion connected to the network by 2015."

The first thought that struck me was "What do the fingers of instability and the critical state look like in this scenario"?

The thought was a response to the lead in, "And now for something a little more positive". Based on the preceding paragraphs, we should also expect some risk of negative consequences with the growth of inter-connectedness to more and more economically and socially interacting individuals.

It does seem to me that the expansion of the interconnection, over the long-term, will be accretive to the fingers of instability in unknowable ways, just as the growth of the derivatives in the past led to interconnections that were (apparently) unknowable prior to the critical state being exceeded.

A side effect of this is the more frequent changing of strategies by the "game players", eliciting the consequences upon which you touched earlier.

It therefore seems to me that the initial "additional 0.59% of growth in GDP" attributable to the addition of 10 phones per 100 of population, while seeming long-term positive and stability-inducing, ultimately leads to more frequent and severe unanticipated consequences.

I'm not advocating one way or the other. I'm only doing what is my wont: taking newly acquired knowledge (thank you again) and extending it to areas that seem to me to be impacted by the attributes you've detailed.

I would appreciate reading your thoughts on this.

I wish I had discovered you years past. Now I have to begin (I have no choice - it's my nature) researching all you've offered before this.

HardToLove

Oct 04 09:35 AM

[One Eyed Guide:]

Great article.
There is two concepts of Minsky you did not mention that has investment implications and also says that current deficit spending may be OK.
The first is that "We can, so to speak, stabilize instability" in the economy just like we do in other naturally unstable systems, for example, by using retaining walls to stop sand avalanches.
Second is that ""the shape of the business cycle has changed; inflation has replaced the deep and wide trough of depressions." You believe that the inevitable inflation that follows today's massive deficit spending will be catastrophic.
Minsky theories do not assume that inflation is bad but are concerned with the lack of economic stabilizing mechanisms. Without new rules and regulations we will have a catastrophic outcome: it will not be from the deficit but rather from the continuation of market instability.
In any case, there will be an increase in inflation after we exist from the current liquidity trap which prudent investors should be aware of. If nothing is done to fix problems causing instability in the markets, this inflation could cause serious problems.. or it could be some other grain of sand...we just don't know which one will bring down a system that continues to be unstable.

Oct 04 09:43 AM

[searcher:]

Similarly, a landscape of semi-arid scrub grown thick through a season or two of greater than normal rainfall is susceptible to catastrophic fire storm in a dry season. The random lightening strike that normally sparks a fire that is contained by diverse topography and growth now becomes unbounded and consumes all. It's going to happen, so you need fire breaks, eschew structures and if such are unavoidable, clear the surrounding brush and have fire control available.

Oct 04 11:30 AM

[derryl:]

Another great article from John.

H.T.Love wrote, "It therefore seems to me that the initial "additional 0.59% of growth in GDP" attributable to the addition of 10 phones per 100 of population, while seeming long-term positive and stability-inducing, ultimately leads to more frequent and severe unanticipated consequences."

It seems to me that the more communication we have the more people will be acting from the same "concensus" information, which will exacerbate the problem of herd movements. That is, what would be small avalanches if only a few grains of sand/people possessed and acted on a certain piece of information, will become large avalanches when many people act together.

Think of major retail sales events. Without effective mass advertising only a few people would become aware of the sale and flock to the store, but with cellphones and tweets 1000s of people converge and create pandemonium. Remember this past year when a woman was crushed to death at a Walmart sales event?

Anyway, just a thought on what this kind of information linkage might lead to.

Oct 04 12:21 PM

[John Lounsbury:]

John - - -

Great discussion of instability. I know you like to think outside the box so let me wander outside the sandbox.

Why do all the grains of sand have to be added to one point, piling up until a steep, unstable pyramid is formed, leading to collapse? Why can't the sand be added across a broad area, with the base ever expanding. This could lead to a structure that never achieves steep walls.

This is analogous to comparing the financial system structure we have achieved to a broad, and diverse structure that never sees the fatal fingers of instability except in a very local way. Interconnectedness may be very productive, but interdependence can produce collapse (domino effects). Maybe we need to find a way to divorce the two.

The fatal flaw of primal capitalism is that it allows the concentration of economic power until it eventually becomes so concentrated that there is nothing left to support it.

The fatal flaw of communism is that it has the lethal concentration of economic power at conception.

Unregulated capitalism matures into the fatal condition; communism is born with it.

The ideal economic system has yet to be devised. Perhaps it never will be. How can you prevent unsustainable concentration of economic power without removing incentives for the masses to strive for economic advantage?

Oct 04 12:51 PM

[SeeTheLight:]

Happy 60th.

A fine view of the mess we are truly in. I think most people on here would agree that sooner or later we will have to pay the piper for years and years of easy money stability. The question is not "if" but "when". Let's face it, we could have another "easy money" party left in us, in fact we're right in the middle of it.

But the problem is each subsequent party has a larger hangover and requires more liquid(ity) to get the party going again. It's hard to know what to do in this environment since we're either going to have one heck of a farewell bash or this thing might be the time that there isn't enough liquid left to kill the hangover, either way I agree with you, it's an exciting and dangerous time to be an investor.

The pendulum seems to swing daily between a deflationary depression and an hyper-inflationary stagnating banana republic. It is difficult to position oneself since they are polar opposites.

Do not be surprised that people are reading your writings, when in a time of instability it is important to listen to as many learned opinions as possible, because no one can know for sure what the future will bring, but we can prepare for whatever may arrive.

Good Luck all.

Oct 04 01:08 PM

[SeeTheLight:]

John,

The answer is as simple as looking in a mirror, when all the grains of sands are fundamentally flawed, driven by the opposite emotions of greed and fear, how can a solid base be created. Even if one were to devise the perfect system, or perfect plan, if the medium of execution is flawed the type of stability you are trying to envision is simply fantasy.


On Oct 04 12:51 PM John Lounsbury wrote:

> John - - -
>
> Great discussion of instability. I know you like to think outside
> the box so let me wander outside the sandbox.
>
> Why do all the grains of sand have to be added to one point, piling
> up until a steep, unstable pyramid is formed, leading to collapse?
> Why can't the sand be added across a broad area, with the base ever
> expanding. This could lead to a structure that never achieves steep
> walls.
>
> This is analogous to comparing the financial system structure we
> have achieved to a broad, and diverse structure that never sees the
> fatal fingers of instability except in a very local way. Interconnectedness
> may be very productive, but interdependence can produce collapse
> (domino effects). Maybe we need to find a way to divorce the two.
>
>
> The fatal flaw of primal capitalism is that it allows the concentration
> of economic power until it eventually becomes so concentrated that
> there is nothing left to support it.
>
> The fatal flaw of communism is that it has the lethal concentration
> of economic power at conception.
>
> Unregulated capitalism matures into the fatal condition; communism
> is born with it.
>
> The ideal economic system has yet to be devised. Perhaps it never
> will be. How can you prevent unsustainable concentration of economic
> power without removing incentives for the masses to strive for economic
> advantage?

Oct 04 01:15 PM

[H. T. Love:]

A perfect analogy for what I was thinking. The only divergence was that I was thinking in terms of business, investing, trading, ... interactions. But there is no reason that the critical state can't be achieved by "the man on the street". The subsequent avalanche would be in what sector: government, business, social fabric, ... all?

That's the uncertainty that got me thinking of it.

Thanks for the reply and a great example.

HardToLove


On Oct 04 12:21 PM derryl wrote:

> Another great article from John.
>
> H.T.Love wrote, "It therefore seems to me that the initial "additional
> 0.59% of growth in GDP" attributable to the addition of 10 phones
> per 100 of population, while seeming long-term positive and stability-inducing,
> ultimately leads to more frequent and severe unanticipated consequences."
>
>
> It seems to me that the more communication we have the more people
> will be acting from the same "concensus" information, which will
> exacerbate the problem of herd movements. That is, what would be
> small avalanches if only a few grains of sand/people possessed and
> acted on a certain piece of information, will become large avalanches
> when many people act together.
>
> Think of major retail sales events. Without effective mass advertising
> only a few people would become aware of the sale and flock to the
> store, but with cellphones and tweets 1000s of people converge and
> create pandemonium. Remember this past year when a woman was crushed
> to death at a Walmart sales event?
>
> Anyway, just a thought on what this kind of information linkage might
> lead to.

Oct 04 01:31 PM

[untrusting ...:]

John,
Yet another insightful and helpful article. Thanks for posting it.

"You are going to have to be far more nimble and prepared for this next crisis, should it arise, than you were for the last one. Over the next few months, I will be devoting some space to helping us think through how we do that."

Looking forward to your future articles about how us small investors can best attempt to perserve both return of captial as well as return on captial. No easy task for the last decade and probably will prove even more challenging in the future.

Oct 04 02:37 PM

[Ivo P. Jane...:]

Congratulations on your 60th birthday, John! Just remember, you don't turn into a pumpkin just because you turn 60. In the entire Universe, only human beings can suffer from, self-inflicted, premature cognitive perception. Ivo

Oct 04 02:54 PM

[Old Trader:]

John,

Let me add my congratulations and best wishes on your birthday. While I was superficially aware of Bak, Tang and Weisenfeld's work, this article added greatly to my understanding of its implications.

I've been following your writing from about 18 months, but I think it would behoove me to dig even farther back to your previous work/writing.

An outstanding collection of comments, as well!

Oct 04 03:24 PM

[ebworthen:]

John,

Happy Birthday. Thank you for your thoughts and especially your optimism in the face of instability.

Another example versus sand would be water. There is a constant amount of water on the planet, however, it's form and distribution changes. Typhoons, droughts, avalanches, flooding, ice ages; all occur even though the amount of water is constant - it just changes form and location.

Water follows the path of least resistance, and this often causes the calamitous events associated with it. I think money has the same property, and one person's flood is another person's drought.

Hope you've had a great weekend, I look forward to devoting more of my time to your thoughts and writing.

Regards,
Eric

Oct 04 05:06 PM

[Roger Knights:]

"Based on the preceding paragraphs, we should also expect some risk of negative consequences with the growth of inter-connectedness to more and more economically and socially interacting individuals."

Flash mobs.

Oct 04 05:15 PM

[M. Dodds Je...:]

Thanks for the excellent article, and I also appreciate the many thoughtful comments posted above. While your column and the sources you cite are much better thought-out than my own inarticulate conceptions of the causes of instability and catastrophe in financial (and other) systems, I have long been of the view that even the attempts to build "retaining walls" in the sandpile will ultimately lead to greater catastrophes, if too much reliance is placed upon them.

Two examples readily come to mind: (1) A century of "forest management" (i.e., fire suppression in our national forests) that eventually resulted in massive and much more destructive fires, such as the Yellowstone conflagration in the 1980s and the burning of much of the West each summer in recent years; and (2) The establishment of our system of deposit insurance as part of the New Deal, which has contributed to decades of relative stability our financial markets. But like fire suppression, it has also lead to unrealistic expectations as to risk, with banks like JP Morgan-Chase taking advantage of that government backstop to build a monstrous pyramid of derivatives that may ultimately lead to an unprecedented financial and social disaster when it collapses -- a teetering pyramid too large to contain or stabilize despite the best efforts of "Helicopter Ben" and all the Fed's printing presses; a pyramid of risk that Chase quite probably could not have constructed without the supposed safety of the FDIC guarantees to its depositors....

Oct 04 05:56 PM

[Value Added:]

John, thanks... I thoroughly enjoyed this.

For what it's worth, my simple explanation for the mountains of instability we face is this: all our leaders in politics and business are incentivized for short-term gains, and wholly personal gains at that. No one works with a view to the distant horizon, or a view to the next generation.

Now while this explanation of mine may be entirely too simplified, at least it did give me a fabulous rush of endorphins. (Grin!)

Oct 04 09:28 PM

[carey_jim:]

John, your articles will continue to be interesting as long as you don't CARE what your readers think (humbly or otherwise) and continue to write what YOU think.

A note on Nietzsche:

Nietzsche announced that God is dead. He didn't say that he, Nietzsche, had killed God. He simply said that he looked around and noticed that the best human beings no longer thought of God as a living concept.

When Nietzsche said that God is, in fact dead, he was saying that we can no longer believe in a set of immutable laws that govern the universe and that we human beings can no longer have the luxury of thinking that if we discover these immutable laws of God and live by them we will be saved, either individually or collectively.

He also said that from now on we human beings will have to rely on ourselves for our salvation and, what is even more profound, our salvation is not guaranteed.

He said, from now on out, there is nothing higher than man on earth.

He told us that we can rejoice over the fact that man is only a naked ape if we see him as a rope stretched over the abyss leading to an ideal man of the future, or we can despair over the fact that man is an only ape and wait for the end.

Oct 05 01:00 AM

[TheSnail:]

John,

Happy Birthday. And thank you for sharing your newsletter for free. I am still amazed I was able to read your insights for no charge over the past two years.

To fully appreciate what you are saying in this article, the reader needs to distinguish between "a tipping point " - corresponding to the onset of a sand avalanche in your sand pile, or one of any number of external forces that would cause a perfectly balanced tetter-totter to tilt one way or the other - and the constraints imposed on the system, which alter the conditions under which the tipping point occurs.

Using your sandpile example, there is a significant difference between a sandpile resting on a flat surface, which has no external constraints on it, and a sandpile formed within a ring. For a properly sized ring the onset of a significantly sized sand avalanche will be delayed, relative to the number of sand grains that have fallen, due to the external constraint imposed on the system.

If we now let the ring be comprised of bricks, then each brick represents an external constraint that aids in preventing undesirable sand avalanches (or a financial system collapse). In this analogy, some of the bricks represent the laws needed to provide the proper checks and balances in a financial system. Some of the bricks represent sound monetary policies by the Fed. And so on.

As such the discussion of causes of the financial crises corresponds to the removal of bricks or constraints that provide the "guide rails" under which the system operates smoothly.

And thus I would argue that the key underlying causes of the financial crises are identifiable (i.e., which bricks are missing). And the particular grain of sand or butterfly that initiated the avalanche is of secondary importance. (Very interesting, of course, but of secondary importance.)

Fellow scientist/engineers will recognize that I am simply pointing out the importance of boundary conditions on any system. A porous boundary will hold no water. And clearly our financial system had plenty of holes in at the time the butterfly initiated the tipping point.

Regards,
Richard Geist

Oct 06 12:11 AM