Why this crisis is not over – Part 2

For the last 3 years the only plan our leaders have had, has been to ‘kick the can’ down the road. They wouldn’t admit to it of course, but that is what their actions of the last 3 years have amounted to. Putting off making any real changes or reforms that the bankers would not like, and instead using public debt and tax to buy time. Our leaders have decided on our behalf without consultation or debate, to buy up and guarantee the banks’ private debts. We pumped hundreds of billions into the banks and banking system – basically a near to zero percent interest loan to the banks, for them to speculate with. That, of course, leaves public sovereign debt levels in a perilously bloated state but that has its attractions too, if your ideological bent is to cut down welfare, National health services, labour laws and all the rest. 

For those who are interested you can read the IMF blue print for what is now being imposed throughout Europe in an article I wrote back in December of 2010 called The Cost of the Bail Out – Just your Democracy ,and in a follow up in April called The ongoing IMF attack on European Democracy.

The problem is, kicking the can has not worked and will not work, and here is why.

‘Kicking the can’ works if you live in a linear world. By ‘linear world’,  I mean one whose underlying mathematical rules are linear. Linear mathematics is the mathematics of the well behaved, every day world.

In a world governed by linear rules, kicking the can can work because you can simply put off the problem to a more convenient time. The problem may get a little worse in the mean time, but in a linear world governed by linear mathematics, a little worse is nothing to worry about. Sadly, in the non-linear world, a little worse, a little more, can make huge a difference.

In the Linear world you hit a nail in to a wall and the nail goes in a bit. Hit it harder, it goes in a bit more. That is the linear world. Cause and effect are linked linearly. A small cause – hit the nail lightly, has a proportionately small effect. And any incremental increase in how hard you hit the nail only increases the end result by a predictably small amount. The linear mathematics of that world allows you to predict exactly outcomes from their causes.

The non-linear world, however, is when you bang the nail in and the house falls down. It takes us by surprise. It is the stuff of slap-stick comedy and of unforeseen disaster. In non-linear mathematics and the non-linear world, small causes can have huge results. 

“Can have” is the key here. The real danger is not actually the size of the surprise but the fact that it doesn’t always happen. In the non-linear world SOMETIMES, small causes have huge effects but not always and you can’t tell which small action is going to be the one that brings the house down. Sometimes you bang in the nail and the outcome seems linear. There is no huge disaster. And that is the danger because it lulls us, and those who make profits from banging in those nails, in to believing they don’t live in a non-linear world. It is, they become convinced, “for all practical purposes” a linear world with linear risks. They start acting as if everything is stable and at equilibrium. 

The archetypal image of the linear world is a ball in a bowl.  If the system is disturbed in any way, it is like giving the ball a shove. We all feel the disturbance as things are shoved off centre but the natural make-up of the system returns the system back to its stable equilibrium at the bottom of the bowl. This is equilibrium economics in one image. 

The archetypal image of  non-linearity, on the other hand, is the sand pile.  Most of the systems we live in, on, and upon which we depend, both environmental and financial, are very non-linear. 40 years of science has made this clear to all except those who have their eyes shut and their fingers in their ears – our leaders.

If we want an image of the underlying mathematical and physical nature of our world we should not imagine ourselves living in a gently self correcting bowl, we should imagine living on the side of a sand pile. Sand piles have avalanches.

The image of the sand pile was first proposed and made popular by the physicist Per Bak. He’s now dead and a great loss to science.

The point of the image is that as the sand pile grows nothing much happens. Taken as a little world – a model – it starts out as a benign place to live. Sand gets added but nothing untoward happens. It is linear. The sand piles up. No single grain of sand has any great effect or significance. 

For our purposes imagine the sand pile to describe the pile of debts accumulating in the global financial system. Not the debt in any one bank but the debts of the whole system. 

For a long while the debt pile grew without a murmur.  Each bank wanted to create as many debt backed assets, securities and derivatives as possible. Create the debt agreement (mortgage for example) securitize it and sell it on in to the global system.  Every bank profited from creating the debts and not one of them worried about where the debts went or how many there were. So far as the banks were concerned the debts just ‘went in to the system’, the market absorbed them. The market could ‘handle’ them, could make them safe. The invisible hand was bomb disposal expert as well.

Now also remember that with any debt come a risk. So if you like, the pile of sand models the debt itself and also the risk of that debt not being repaid.  But as far as the banks are concerned, like other polluting heavy industries, the profit was what counted and the waste – in the banks case the risk associated with the debt, is pumped out of a pipe to go who cares where.  Intellectually the banking and finance world are where manufacturing was in the 1970’s. All aggressive denial and wilful ignorance. “It’s not my debt and anyway it’s not doing any harm.”

In old fashioned banking, of only half a generation ago, both the debt and the risk were owned by each bank and both stayed with the originating bank.  In modern banking, the model is no longer ‘hold until maturity’ it is now originate and sell on. A bank creates a debt agreement but then does not hold that debt waiting for the repayments. It securitizes the debt and sells the security as an investment or asset.  The bank thus makes its profit by selling not only the income stream but also any risk associated with it.

If you talk to any banker, particularly those concerned with risk – the risk managers – they will tell you that this selling-on of the risk makes the bank safer. No longer is risk piling up in the bank. Instead the risk is sold on into the larger market where people buy and sell it as a commodity allowing risk, they will tell you, to go where it is wanted and sold from where it is not.

But what none of them, none of the banks nor their experts spend time thinking about, is how much debt or risk the entire system can absorb.  So they pour debt and risk in to the market, in our analogy – pouring more and more of it on to the pile. And because to begin with the pile absorbs whatever is poured on to it, the ‘experts’ have the comfortable notion that this is just how their world is. The market, AKA the pile of debt and risk, seems to them to be linear.  They study it with the linear mathematics they are used to and because it seems to act in a linear way this re-enforces their certainty that their world is linear.

They are like polluters each pumping their bit of waste in to an inland sea. Each models the dilution of their bit of pollution and are happy to report that they are well within safety limits. Not one of them asks what the carrying capacity of the entire sea is.  If there is some local bloom of toxic algae or a sudden die off of fish they look for some local cause, some unexplained local fluctuation. A rogue polluter or machine malfunction.

So it is with both debt and risk in the global financial system. Every day all the banks in the world are hard at work putting debt and risk in to the global system. Every day they are making new debts and new risk and selling that risk in to the market. They create securities and then layers of CDS insurance around and on top of them; a web of debt and risk whose flows and currents no one in the world has any clear idea of. Neither the scale nor the location.

And so the sand pile grows and the physical strains inside it grow until it reaches what Per Bak and physicists call a state of “self organized criticality,” A state of being perpetually and massively off balance, far from any equilibrium, poised in a critical state just one sand grain away from collapse. It is called ‘self-organizing’ because the system will tend to this state naturally. Sand dunes have the shape they do because they are poised between the wind blowing more sand on to them and avalanches sliding sand away when the pile is unstable.

This is the exact opposite of what the economists and financial experts think is going on. They think their world is poised at the comfortable bottom of a gentle bowl. Whereas in reality it is poised like a man at the top of a cliff is poised, on his tip toes trying hard not to fall over the edge. The slightest breath of wind and he is gone.

The financial system of debt and risk, I am arguing, fits this dynamic and has this nature.  The banks pour debt and risk in because it profits each of them individually. They see the risk ‘going away.’  Just like a smug polluter thinks his waste has ‘gone away’ down the waste pipe. He never wonders where it goes or whether it is building up somewhere. And so it accumulates out of sight and mind till the system reaches a silent and unheralded criticality. That is where we are now and where we have been since 2008 at least – on the edge of criticality. The pile of debt and risk is at its critical maximum. As more debt and risk is poured on landslides dislodge some of it.  We have periodic crashes and slips whenever the system cannot sustain the whole. And this will continue for as  long as well keep creating more debt and more risk.

Each slip, we look for ‘the cause’ without ever realizing that the slips were not ’caused’ in the sense of some extraneous event ‘causing’ an otherwise fine system to malfunction. The slips are caused by the nature of the system reaching a state where such slips are what happens.

We have done nothing at all to lessen the inflow of debt and risk. In fact we have as a stated part of our ‘recovery’ policy to increase the flow.  What no one is recognizing is that the whole global system is saturated with debt and risk, the pile is at critical. And so as we ‘kick the can’ we are in fact just allowing more debt and risk to pile up until something slips and the saturated, critical system forcibly sheds another landslide’s worth of risk and debt. on to ordinary people who are being expected to pay to clear it up.

Greece did not manage to reduce its over all debt. It has been trying to spend less, but its debt and its risk have increased. In other words, the policies being followed are precisely the opposite of what might help. They are making the actual problem worse.

In fact I would go further and argue that the entire risk management paradigm of modern banking is completely flawed because it does not recognize the systemic and non-linear nature of the system into which it is piling debt and risk. It is thus the recipe and creator of it own on-going and recurring crises.

What we have seen over the last decades as this model of securitizing debt and risk and selling them on, out of sight-out of mind has grown, is a pattern familiar to students of Evolution.  It is called Punctuated Equilibrium.  Long periods of stasis where it seems as if everything must be in some natural and perfect balance and equilibrium, brutally punctuated by short periods of extinctions where the formally stable system seems to go in to a paroxysm of death and change. Small events seem to trigger these periods of extinction.  A small change in one species sets off avalanches of extinctions.

That is the financial system we have built and if we do not change it, and stop piling risk and debt in to it without understanding the systemic effect, then we will face our own financial extinction.