macroresilience

resilience, not stability

Notes on the Evolutionary Approach to the Moral Hazard Explanation of the Financial Crisis

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In arguing the case for the moral hazard explanation of the financial crisis, I have frequently utilised evolutionary metaphors. This approach is not without controversy and this post is a partial justification as well as an explication of the conditions under which such an approach is valid. In particular, the simple story of selective forces maximising the moral hazard subsidy that I have outlined is dependent upon the specific circumstances and facts of our current financial system.

The “Natural Selection” Analogy

One point of dispute is whether selective forces are relevant in economic systems. The argument against selection usually invokes the possibility of firms or investors surviving for long periods of time despite losses i.e. bankruptcy is not strong enough as a selective force. My arguments rely not on firm survival as the selective force but the principal-agent relationship between investors and asset managers, between shareholders and CEOs etc. Selection kicks in much before the point of bankruptcy in the modern economy. In this respect, it is relevant to note the increased prevalence of shareholder activism in the last 25 years which has strengthened this argument. Moreover, the natural selection argument only serves as a more robust justification for the moral hazard story that does not depend upon explicit agent intentionality but is nevertheless strengthened by it.

The “Optimisation” Analogy

The argument that selective forces lead to optimisation is of course an old argument, most famously put by Milton Friedman and Armen Alchian. However, evolutionary economic processes only lead to optimisation if some key assumptions are satisfied. A brief summary of the key conditions under which an evolutionary process equates to neoclassical outcomes can be found on pages 26-27 of this paper by Nelson and Winter. Below is a partial analysis of these conditions with some examples relevant to the current crisis.

Diversity

Genetic diversity is the raw material upon which Darwinian natural selection operates. Similarly, to achieve anything close to an “optimal” outcome, the strategies available to be chosen by economic agents must be sufficiently diverse. The “natural selection” explanation of the moral hazard problem which I had elaborated upon in my previous post, therefore depends upon the toolset of banks’ strategies being sufficiently varied. The toolset available to banks to exploit the moral hazard subsidy is primarily determined by two factors: technology/innovation and regulation. The development of new financial products via securitisation, tranching and most importantly synthetic issuances with a CDS rather than a bond as an underlying which I discussed here, has significantly expanded this toolset.

Stability

The story of one optimal strategy outcompeting all others is also dependent on environmental conditions being stable. Quoting from Nelson and Winter: “If the analysis concerns a hypothetical static economy, where the underlying economic problem is standing still, it is reasonable to ask whether the dynamics of an evolutionary selection process can solve it in the long run. But if the economy is undergoing continuing exogenous change, and particularly if it is changing in unanticipated ways, then there really is no “long run” in a substantive sense. Rather, the selection process is always in a transient phase, groping toward its temporary target. In that case, we should expect to find firm behavior always maladapted to its current environment and in characteristic ways—for example, out of date because of learning and adjustment lags, or “unstable” because of ongoing experimentation and trial-and-error learning.”

This follows logically from the ‘Law of Competitive Exclusion‘. In an environment free of disturbances, diversity of competing strategies must reduce dramatically as the optimal strategy will outcompete all others. In fact, disturbances are a key reason why competitive exclusion is rarely observed in ecosystems. When Evelyn Hutchinson examined the ‘Paradox of the Plankton’, one of the explanations he offered was the “permanent failure to achieve equilibrium” . Indeed, one of the most accepted explanations of the paradox is the ‘Intermediate Disturbance Hypothesis’ which concludes that ecosystem diversity may be low when the environment is free of disturbances.

Stability here is defined as “stability with respect to the criteria of selection”. In the principal-agent selective process, the analogous criteria to Darwinian “fitness” is profitability. Nelson and Winter’s objection is absolutely relevant when the strategy that maximises profitability is a moving target and there is significant uncertainty regarding the exact contours of this strategy. On the other hand, the kind of strategies that maximise profitability in a bank have not changed for a while, in no small part because of the size of the moral hazard free lunch available. A CEO who wants to maximise Return on Equity for his shareholders would maximise balance sheet leverage, as I explained in my first post. The stability of the parameters of the strategy that would maximise the moral hazard subsidy and accordingly profitability, ensures that this strategy outcompetes all others.

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Written by Ashwin Parameswaran

March 13th, 2010 at 5:22 am

5 Responses to 'Notes on the Evolutionary Approach to the Moral Hazard Explanation of the Financial Crisis'

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  1. I could offer several minor demurrals, which might help you to clarify your thoughts. There’s a lot packed in this post, and I am only writing a comment, so be nice.

    The Law of Competitive Exclusion depends on a peculiar framing of the definition of niche, which can obscure a critical aspect of your argument. Most strategies have logical complements: you zig, I zag. Your strategy for zigging may exclude all other ways of zigging, but leave zagging viable. Or, not. I would think the latter case is the one you would want to establish.

    In manufacturing and distributing a product, a variety of logical polarities or ranges of strategies can be imagined: custom v. standard; build-to-order vs build-to-spec, capital-intensive vs. labor-intensive, high-quality vs. low-price, and so on. In some industries — auto-making would be one — one strategy has become so efficient as to completely dominate. Mass-production of automobiles and their major components advanced in technical efficiency to such an extent that it pushed all, but a tiny handful of custom, labor-intensive, luxury builders out of the business. Even a Rolls-Royce uses a Chevrolet’s hydramatic transmission — in cost and quality, mass-production can completely dominate.

    Another example might be PC operating systems. The deft exploitation of network economies, combined with very large increasing returns to scale in software and photo-lithographic reproduction, allowed Microsoft and Intel to create a near-monopoly for one framework design, in a space where there are a myriad technical variations possible. One might notice that Wintel has kept AMD, Apple, Firefox and other carriers of residual or latent variety of a very limited sort, alive, as well as vast schools of pilot fish.

    Really, there’s no way to know, say, whether the standard adopted for railway gauge is “optimal”. One standard will, eventually, tend to dominate, because of the economies of having a standard, which is not quite the same as the merit or demerit of a particular standard. The world will adapt to the standard, and if the standard delivers sufficient economies, many of the adaptations will, in fact, be compromises, in which costs are incurred to realize the economies offered by the standard. Any one gauge will be sub-optimal for many — indeed, conceivably, every — use: too light for hauling coal; too slow for passengers, etc. Intel’s admittedly versatile microprocessor isn’t perfect for anything — but it combines power, quality and cheap.

    I just mean this comment to be suggestive. I think you might be putting a bit too much weight on environmental stability as a cause of homogenization and loss of diversity.

    When I gaze at the financial sector, what I notice is that financial intermediaries are, by definition, pursuing a difference in returns. When the success of their strategies, or exogenous forces — either one — make that difference narrow or disappear, they get in trouble. So, they want to manipulate thet difference, and are vulnerable to system feedback loops that narrow it.

    If I wanted to identify regulatory strategies to stabilize the system, I would want to give some institutions in the system secure control of a source of funds and/or a target market for lending, on which a reliable rent could be earned. Executives wanting to protect that economic rent would adapt strategies at odds with the strategies of executives, who had to pay a competitive rate for funds.

    The gerbil on a treadmill aspect of pursuing higher rates of return, which in turn, drives the cost of funds higher, seems like an important aspect of the strategic problem, which lies alongside the self-deception about what’s arbitrage and what is risk.

    The other aspect of the current “environment” that troubles me a bit is the domination of universal banks. The meta-strategic possibilities trouble me, greatly.

    I am really enjoying reading back through your blog. You are tackling a big problem with a lot of energy, and I like it.

    Bruce Wilder

    14 Mar 10 at 2:28 pm

  2. Bruce – I’m glad you enjoy the blog! Your comment has many good points and I can’t find anything in it that I would violently disagree with.

    On the subject of niche differentiation – Yes, essentially I am asserting that the superior strategy of zigging does not even leave zagging viable for two reasons: Firstly, the extent of leverage permissible in the large banks means that the free lunch is just too large for any other “niche” to compete in the eyes of a shareholder. Even if some shareholders have a preference for a different risk profile, I fear that the size of the free lunch blows these preferences out of the water. Secondly, as you mention, there are no “rents” left in the system especially in the last 25 years or so. So the substantial base of sleepy banks that took no risk at all does not exist any more. Incidentally, this factor was key in the S&L crisis I think.

    On the subject of what are the key causes for the loss of diversity, I agree that there are many other causes. My current obsession with the stability argument is really only a function of the fact that I’m trying to write everything I have on one strand of thought before moving onto something else. So just a few more posts on stability after which I will move onto other pastures!

    On universal banks, I share your concerns and hopefully a post on the topic will be up soon.

    Lastly, I would just stress that the simple caricature of evolution that I have used above is only relevant for the moral hazard story for various reasons I have outlined above. I wanted to make that clear and move on because the approach I use in the rest of my posts on the macroeconomy will be a lot messier.

    Thanks for the comments

    MR

    admin

    14 Mar 10 at 6:09 pm

  3. In trying to get clarity on what agents are being selected for/against it helps to remember that real world systems are all multilevel and coevolutionary. Genes, genomes, organisms, groups of organisms etc are all undergoing evolution at the same time but just at radically different time scales.

    It does make sense to ask which is the most dynamic at any given time or which is “primary” as you have done. In the context of economic systems, Beinhocker argues (Origin of Wealth) for the primacy of “business plans” (or strategies in your parlance) rather than humans or organizations. That is the strategies are the agents being selected for or against….

    Rafe Furst

    22 May 10 at 9:57 am

  4. Rafe – Thanks for the comment. I’m not opposed to the idea of the primacy of strategies, but still find it worthwhile to dig down to the level of an individual. Let’s just say that I prefer my explanations as micro-founded as possible. Obviously the coevolutionary, hierarchical nature of the problem makes this kind of analysis messier than most people would prefer.

    admin

    30 May 10 at 8:07 am

  5. […] in Diversity: As I mentioned here, “In an environment free of disturbances, diversity of competing strategies must reduce […]

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