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Finding Darwin in finance

JINOY JOSE P | Updated on November 12, 2014 Published on November 12, 2014

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Survival of the fittest?

Not quite so obvious. This is about the link between evolution and financial crises.

What's that?

Countries can avoid financial crises if they stop talking about unnecessary regulation and understand that the economy is an ecosystem, according to a new report in New Scientist, which quotes complexity theorists Eduardo Viegas and Henrik Jeldtoft Jensen (with the Centre for Complexity Science at Imperial College London) and Geoffrey West (a theoretical physicist at the Santa Fe Institute, New Mexico in the US).

So what’s the science or economics?

In economics, most agree that over time, the forces of supply and demand reach an equilibrium. Similarly, in finance, the concept of “fair price” – when the value of an asset reaches a middle point at which a buyer and seller agree – is a key idea. According to these theories, financial crises occur when the system moves far away from the equilibrium. On this cue, spotting a crisis should be easy. The scientists say we need only to track the distance of key metrics from equilibrium. Which means spotting a crisis should be easy.

But this hasn't been happening, right?

Indeed. Economies and markets follow theories neither in letter nor spirit. Just like evolution in the natural world, markets and the world of finance experience periods of stability, uncertainty and sudden chaos. So, to prevent markets and financial companies from melting away, and taking down the whole system, the thumb rule is to retain the evolutionary character of financial systems. Let them be diverse.

Like in the evolutionary process, a big change does not pop up on one fine morning; it's the result of long, complex processes that start with small changes. Spotting them is the trick.

Are you saying we're not doing it now?

Not in the ideal way. Traditional economic and financial analysis, say these experts, mostly explain economic events by making arbitrary links between past events and the present. The scientists say this is much like saying a person is diabetic as she ate too much fast food recently, whereas the disease has more to do with genetics and lifestyle. It builds up without “betraying any symptoms”. It’s the same with financial crises.

Interesting!

In both instances, just detecting the phenomena is not that important. What is more important is understanding the “propensity for the phenomena to emerge”. Financial crises are not the outcomes of specific economic events but evolve over time. Inevitably, they build imbalanced ecosystems — like monopolies — that nurture a few gargantuan but sluggish “too big to fail” entities, alongside very small, niche firms.

And the result of this build up is obvious.

Yes, the biggies grow bigger but do not improve their performance, say the complexity theorists. Unrestrained growth of one or a few companies can lead to a systematic imbalance much like the unrestrained growth of cells causes cancer.

So, what's to be done?

The scientists say free markets have significant flaws that will eventually lead to crises. So regulation should focus on slowing down the development of the ecosystem's imbalance. Therefore, the ideological debate as to whether markets require more regulation or can regulate themselves should change.

New regulation should be brought in only if it helps maintain the overall diversity of the economic players in the system. But sadly, the scientists point out, most regulation since the 2008 financial crisis has been counter-productive; it has ended up reducing diversity and paving the way for even bigger problems.

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Published on November 12, 2014
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