No one was left unscathed by the global economic crisis that started in 2008. Everyone felt the shockwaves echoing from the crash triggered by the excesses of Wall Street. Many didn’t just feel shockwaves. The situation crashed right on top of them and crushed their hopes and dreams.
Some suffered more than others. Those who had fortunes at stake lost a good part of it. Many lost their jobs. Those who needed a home the most were driven out from theirs. Lives were lost. Across the world, from Italy to Greece and across the ocean to the United States, many felt an extreme sense of hopelessness. Suicides directly attributable to joblessness, foreclosure, or debt added doom to an already gloomy climate.
This is not the first time that a financial event of this magnitude has happened. From the tulip mania that afflicted Amsterdam’s stock market in the seventeenth century to the Great Depression of the 1930s to the dotcom bubble in recent memory, we have witnessed how the financial sector affects individual lives on a massive scale.
The quest for answers has led experts to look beyond traditional sources of enlightenment. If mathematics can’t make sense of the mess, maybe biology can? It’s almost intuitive to think of the financial sector as an ecology of firms, institutions and individuals interacting in a web of relationships. After all, economies behave like natural ecosystems in many aspects and have similar basic characteristics. Both feature competition for limited resources; individuals trying to maximize their own return; and competition and exploitation as well as the need for cooperation.
In many ways, this view is supported by free market capitalism, which operates on the premise that largely unregulated competition inevitably leads to the best of all possible worlds. Left to its own devices, the market will arrive at the optimal price for both buyer and seller. Tropical rainforests were used as a metaphor for the free market. In the forest, there are always enough enemies and parasites that will turn on any species that starts being unusually numerous. Eventually, the forest ecosystem corrects this imbalance and equilibrium is restored.
The wanton destruction of tropical rainforests in the 20th century, and its eventual classification as a non-renewable resource, gave the analogy a chilling truth in the light of the global financial crisis. Faced with a big shock, the finance sector might be facing the risk of becoming non-renewable.
The complex nature of the global financial system required a different way of thinking. For many years, scientists viewed the world in a linear manner where simple rules of cause and effect apply and everything could be predicted and controlled. When strange discoveries in quantum physics revealed sub-atomic particles that did not behave according to the rules of cause and effect a new model emerged – the complexity theory. This theory is based on patterns and relationships. It maintains that the universe is full of systems constantly adapting to their environments. Natural ecosystems and global finance are examples of such complex adaptive systems, as are weather systems, the human body’s immune system, and distributed networks such as the Internet.
One property shared by many complex adaptive systems is interconnectivity. Finance has shown a trend towards increased connectivity and a lesser degree of separation. What this translates to in the real world is the high probability of local problems turning into global ones. Natural ecosystems constantly remind us of interconnectivity through extreme weather and food scarcity.
Another property is emergence. Rather than being planned or controlled, agents in the system interact in apparently random manner. These interactions create a pattern which informs the agents within the system and influences the future behavior of the agents and the system itself. The migration of birds is often cited as an example. The theory is that geese fly in the familiar V-pattern because they adjust flying behavior to avoid collision, thus forcing them to fly at the same speeds and towards the center of the flock. Agents in the finance sector behave in a similar manner in that they rely on interactions and the information that these interactions generate to make decisions. Traders lack perfect foresight about what other traders will think and do. At the same time, since a trader’s profits depend on the behavior of other traders, each trader makes investment decisions on the basis of a best guess about what other traders will be thinking and doing.
Perhaps the most contentious of a complex adaptive system’s properties, viewed from the perspective of finance, is diversity. In ocean ecosystems, it has been observed since the 1800s that 40% of fish species have “collapsed,” defined as a fall in population of greater than 90%. Both natural and man-made factors have caused this collapse but what’s important to note is that in species-rich ecosystems the rate has been as low as 10% while in species-poor ecosystems the rate was as high as 60%.
Post-2007, the financial sector seems to have mirrored the fate of fishes as market capitalization fell by 90% or more, equivalent to the collapse of a fish species. Much of this has been attributed reduced diversity mainly caused by the pursuit of returns. In aiming for greater profit, financial institutions migrated to higher yield strategies. Imitation became the norm. Cooperatives transformed into private commercial banks. Commercial banks engaged in investment banking. Investment banks developed hedge funds. Hedge funds competed with traditional investments funds. Universal banking became universal practice. Financial institutions were homogenized, each a clone of the other. The system became a monoculture. In finance as in nature, this makes a system susceptible to disease and disaster.
It is logical to assume that agents with the greatest stakes, those with the highest interconnectivity in the finance ecology, stand to lose the most when disaster strikes. In real systems, however, highly connected species are unlikely to go extinct. A study found that the species most vulnerable are those whose extinction will set off the least amount of secondary extinctions. Are the jobless, homeless and debt-ridden in this category? Do the suicides signal the extinction of a species? Or is this just the complex system adapting to the environment and correcting itself?