Hedging the Apocalypse

by John on May 24, 2012

When some latter-day Aristophanes distills the tragicomic story from the mash of the current Greek econodrama, I’ll wager that it will have much in common with the original story of the Acharnians.  The London Review of Books synopsized the story in a review of a fairly recent translation, which as they note, had come just “in time for George Bush not to read it before he blunders into Iraq”. Aristophanes’ protagonist, an old farmer, visits the Senate to make sure that peace and prosperity are on the agenda in the discussions of the run-up to war. The only one to show up on time, he finds that the Senators are all elsewhere, doing deals to profit from the crisis with Sparta.  He realizes that his only hope of prosperity is to become as rapacious and self-serving as they, and does so with a vengeance.

 To continue the metaphor from Greek myth, the financial market’s recent faith in its own free market dogma and an Icarian disregard for its elder’s wisdom caused its wings to fail and resulting in its 2008 crash to earth. Daedalus’ warning of fatal error if basic operating parameters are disregarded shows that he had conducted a basic potential system-failure analysis (fly too close to the sun,wax melts and feathers detach) when planning his flight with Icarus. Nothing has changed today. The financial sector continues to ignore the hard-won lessons from other complex systems, let alone its own past, leaving our economies exposed to hubris and the Fates.

Consider management, policing and risk in complex systems where really, really bad things happen (even worse than total economic collapse); read Scott D. Sagan’s book, ‘The Limits of Safety: Organizations, Accidents and Nuclear Weapons,’ 1993. It takes previously classified records of failures within the nuclear weapons system and analyzes them against current theories of risk management. He contrasts the ‘high reliability’ school of safety, which believes that …”organizations, properly designed and managed, can compensate for well-known human frailties…” with ‘normal accident theory’ presenting “a much more pessimistic prediction; serious accidents with complex high technology systems are inevitable.”

The book may cause you sleepless nights. Some of the accidents he analyzed avoided nuclear Armageddon only by chance. Vs. the financial system, it shows that  maintaining high reliability in a huge, internationally interconnected, non-transparent banking system with light-speed flash trading, fueled by greed and competition, is not possible. As hundreds of years of banking history shows, failure is inevitable.  Scholarly work like Sagan’s, at Stanford, shows that it should be possible to design a financial structure far less prone to fail and, should it fail, not cause a financial Apocalypse…which hedge fund managers would say is great if you’re on the right side of the deal. Clearly, it’s not the case for the 99% who inhabit Main Street and who depend on stable banking services.

Modern aeronautical engineering provides another example of ways to deal with complex systems with high risk potential. The modern jetliner incurs a weight penalty through redundant systems and load paths, which means higher fuel costs and less payload and thus less potential profit. No sane person would consider riding in an airliner where virtually every critical system and structure represented a potentially catastrophic single point failure, and no Government body would permit such an aircraft to fly commercially, yet Wall Street has resisted all attempts to regulate the financial system that restrict their profits in the slightest. But as recent history shows us, lethal problems occur when pilots believe that the built-in protections of the flight-control computers will protect them in any circumstance, just as Wall Street believed in the ability of its programs to tame and domesticate risk and profit from its sale. Hubris and fate combine, just as dogmatic belief in the ability of markets to self-regulate caused the crash of 2008.

The promise and the problem of sophisticated control systems is described elegantly in William Langeweische’s insightful book, ‘Fly by Wire.’  While it focuses on the safe landing in the Hudson by an Airbus that lost its engines after hitting a flock of geese, at a deeper level it is an eloquent essay on the management of complex systems and the interrelationship between humans and technology. Langewische speculates on the existence of a ‘Titanic Effect’ such that if you believe your ship is unsinkable you will sail at top speed through iceberg-filled oceans. If you believe that markets provide the optimum control system, no external limits are needed, as the market itself will do the job. Bernard Zeigler, the Airbus designer, wanted to build an ‘uncrashable’ airliner but, as with all who ignore the fates, hubris entered, this time in the form of a pilot who had ultimate faith in the system, just as Alan Greenspan had ultimate faith in the power of the free market.

To understand flight as a metaphor for economic performance, consider how the forces in flight are analogous to economic forces, as shown in the following diagram, which shows an aircraft and an economy in a level state, with all forces in equilibrium.

Illustration from Dominican University  Econophysics Working Paper @ John Hulls & Dominican University

 In simplified terms, if you cut spending and thus value generated to meet the demand, then try to maintain velocity, you must lower lift and growth and thus drag and cost of generating value, resulting in a loss of altitude and overall value.   If value generated exceeds the cost of generating it, the economy will climb.  If the velocity is too low, and alpha is increased in an attempt to maintain altitude, the economy will stall, with a catastrophic loss of growth.  Unfortunately, those in the smooth flow at the leading edge, the 1%, will continue to benefit well into the stall though the rest of the population will become increasingly lost in the turbulence as the stall develops. (To visualize a stall, watch?v=6UlsArvbTeo and for a full explanation, see notes below and the link to the Dominican University Working paper)

 Running out of lift and thrust to maintain altitude ends in a landing or an accident as the aircraft stalls.  In 1988, senior Air France pilot Michael Asseline decided to fly low over an airshow at a small, nearby airport to demonstrate the Airbus’ ability to hang in the air at the ragged edge of flight, just as Greenspan and others wished to demonstrate that markets would self-regulate to maximum safe levels of risk. Taking off from Mulhouse, France, the Airbus had 136 passengers aboard what was the aircraft’s introductory flight. Many had never flown before. Greenspan and Wall Street had the entire U.S. population on board their ‘financial flight.’

The Airbus flight-control system, a highly sophisticated computer system, enables even an average pilot, in an emergency, to extract the maximum performance from an airplane in a complex, layered systems of software controls that prevent the pilot from exceeding the aircraft’s structural and aerodynamic limits. The last layer of protection prevents the pilot from pulling the nose so high that the wing stalls, causing catastrophic loss of lift. Similarly, Greenspan and Wall Street believed in the ultimate protection provided by the self-regulating power of markets to price risk in such a way as to prevent economic accident and upset. They were disastrously mistaken.

‘Fly by Wire’ describes in chilling detail how Asseline turned off one layer of protection after another, just as Greenspan and the Congress turned off one layer of financial protection after another. Asseline turned off airspeed and throttle control, and Congress turned off Glass Stegal and disconnected any regulation of any of derivatives. Sinking too close to the ground, the pilot applied power, but the engines take time to spool up to full thrust. Videos of the crash show the Airbus–its nose held high, teetering on the edge of a stall, but with wings level, settled into the trees (there were several clips on YouTube, many of the the commentary and comments  show the incredible ability of the web to support demonstrably false conspiracy theories; links to the actual accident reports are available here.)

The fly-by-wire system would not let Asseline turn off the final layer of safety net which he was depending on for his demonstration, and prevented him from causing a fatal stall, in which case the aircraft would have rolled and plunged near vertically into the forest, killing all aboard. Much like Wall Street and the financial regulatory systems, it did not prevent him from finding a way around the other layers of restrictions, and setting up a circumstance from which he could not recover. Three people out of the 136 aboard died, including a crippled child and a woman who tried to save an eight-year-old girl trapped in her seat.

Likewise, what remained of the financial regulatory systems and safety nets prevented a full stall of the economy along with bailout cash rushing in to keep the needed velocity of financial flow.   As it was, the Obama administration could apply barely enough stimulus to arrest the rate of the descent, but now, almost four years later, we’re only climbing very slowly, at a dangerously slow rate. Any market turbulence might send us hurtling downwards. Once again, the airliner provides an apt analogy. As with the landing on the Hudson, the computer system enabled Captain Sullenberger to expend his resources of altitude and airspeed in the most efficient manner, while his judgement and understanding of the dynamics of flight guided his decisions, and everyone walked away.

However, the true lesson on excessive dependence on complex systems had yet to be learned. A few years later, two younger pilots, with unwavering faith in the control system, distracted by rough weather and a temporary loss of airspeed input,  took an Airbus at 38,000 feet over the South Atlantic, and in just a few minutes, let it fall into the ocean, killing all aboard. Fate allowed the recovery of the black-box recorders from unprecedented ocean depths to provide a chilling tale in the transcript of those final minutes. Langeweische’s book appeared immediately after this crash. Before the black boxes were recovered, he speculated that it would be unbelievable for the pilots simply to misread what the aircraft was actually doing, yet that is what occurred.

This accident would never have happened to Sullenberger, who would have returned to the first principles of flight, trading the assets of altitude to achieve a velocity where maintaining stable flight was possible, yet today we seem reluctant to return to first principals of economics. Austerity believers in Europe’s financial centers proposed budgets that effectively ‘cut the throttle’ and ‘haul back on the stick’ to protect the assets of the financial system. They must now explain how their actions differ from those of the pilots sinking to their doom in the South Atlantic, refusing to understand what their perfectly capable aircraft was trying to tell them. Unbelievably, Romney, grasping Ryan’s dishonest claims of a deficit-cutting budget, refuses to explain how much he will ‘chop the throttle’ of economic demand while ‘hauling back on the stick’ to maintain altitude and thus the asset value of the 1%.

I am sure that our latter day Aristophanes will also point out the hubris of Jamie Dimon and the Wall Street crowd, who dismissed lessons of the Crash of 2008, forgot the bail-out that saved them, then tried to convince everybody that they understood the structure and limits of the economic system better than anybody else, only to watch JP Morgan lose billions in its stock value playing the same game as before. If Greece triggers the next market disaster, our author will point out the fine hand of the Fates at work, since Goldman Sachs and others of their ilk profited from helping Greece cook its books to join the Euro, thus setting the stage for the current tale.  In modern terms, all the complex games with leverage, derivatives and the sale of risk did nothing for Greece or anybody else’s economic performance, other than the financial sector, whose real job is to distribute capital economically.  There is no evidence that all of Wall Street’s innovations of the last couple of decades have done anything to better overall economic performance by, as Greenspan claimed, improving the efficient deployment of capital.

Aeschelus clearly enjoyed writing comedic plays, albeit with a bitter edge. For a modern-day playwright, it will be the tragicomic emergence of the truth that the proper role of government is to protect the 1% from its own excess, and to avoid the repeating rhymes of economic history. More irony? Ignoring the Fates, certain of their management skills and in the ability of their complex, rocket-science systems to protect them, the financial industry poured hundreds of millions of lobbying dollars into Washington in an attempt to insure that We the People and our government did not save them from themselves.

Further Notes (Somewhat geeky)

There are many flight analogies in the financial market, perhaps none more relevant than comments by former Treasury Secretary Larry Summers, who said in an interview at Fortune Magazine’s 2011 Brainstorm Tech conference, “we’ve been flying out of it (the recession) dangerously close to stall speed and doing something about that should be our top priority.”

 I’m a big fan of simulations as opposed to ‘pen and paper’ mathematical models to drive economics towards a more experimental science, as expressed by Julian Reiss of Erasmus University in the Netherlands.  He discusses how they don’t have to be as tightly constrained as pure mathematical models and have been used in a variety of sciences to derive practical solutions to very complex problems.  I’ve been working to develop an easy-to-use ‘flight simulator’ to look for trends in environmental planning in conjunction with the Dominican University ‘Green MBA’ program. The model is also capable of stalling, long and short-term cyclic behavior, and factors income distribution into economic performance. 

 The simulation uses the fluid dynamics of flow over a cambered surface as a physical analog of the economy flying through an atmosphere of potential transactions.  You can see the working paper and learn more about the Cambiant model (from the Latin Cambiare…to bank or trade, and camber, as in the properties of an airfoil) at: https://sites.google.com/a/dominican.edu/econo-physics/working-papers

 Here is a typical output of a simulation run, in this case with conditions set to show effects of degradation of debt stability.

Source: Dominican University Working Paper

 One thing it tells us, as shown in this simulator run, is that the economy, while benefiting the 1%,  is still dangerously unstable, and unlike the crash of ’87, when things subsequently damped down, degrading debt quality and the .com boom set off a series of oscillations ending in the crash of 2008.  The production of value was set as a constant and what is interesting that all the financial innovations that destabilized the markets only produced a very slight growth in total asset value, clearly not worth the loss of stability that they caused. I don’t think we’ve done enough to restore stability and it won’t take much to set the whole thing off again.  Don’t say you weren’t told.

 

 

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