Archive for the ‘System Dynamics’ Category
In a previous post, I quoted Richard Fisher’s views on how bailouts cause business cycles and financial crises: “The system has become slanted not only toward bigness but also high risk…..if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult…..It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.”
Fisher utilises the “incentives” argument but the same argument could also be made via the language of natural selection and Hannan and Freeman did exactly that in their seminal paper that launched the field of “Organizational Ecology”. Hannan and Freeman wrote the below in the context of the bailout of Lockheed in 1971 but it is as relevant today as it has ever been: “we must consider what one anonymous reader, caught up in the spirit of our paper, called the anti-eugenic actions of the state in saving firms such as Lockheed from failure. This is a dramatic instance of the way in which large dominant organizations can create linkages with other large and powerful ones so as to reduce selection pressures. If such moves are effective, they alter the pattern of selection. In our view, the selection pressure is bumped up to a higher level. So instead of individual organizations failing, entire networks fail. The general consequence of a large number of linkages of this sort is an increase in the instability of the entire system and therefore we should see boom and bust cycles of organizational outcomes.”
Quoting from John Sterman’s authoritative book on system dynamics,
” A fundamental principle of system dynamics states that the structure of the system gives rise to its behavior. However, people have a strong tendency to attribute the behavior of others to dispositional rather than situational factors, that is, to character and especially character flaws rather than the system in which these people are acting. The tendency to blame the person rather than the system is so strong psychologists call it the “fundamental attribution error” (Ross 1977). In complex systems, different people placed in the same structure tend to behave in similar ways. When we attribute behavior to personality we lose sight of how the structure of the system shaped our choices. The attribution of behavior to individuals and special circumstances rather than system structure diverts our attention from the high leverage points where redesigning the system or government policy can have significant, sustained, beneficial effects on performance (Forrester 1969, chap.6; Meadows 1982). When we attribute behavior to people rather than system structure the focus of management becomes scapegoating and blame rather than the design of organizations in which ordinary people can achieve extraordinary results. ” (page 28-29)
Sterman’s comment is especially relevant to the current debate on reforming and regulating our financial system. It is misguided to focus on greedy bankers and incompetent or compromised regulators. Bankers and regulators are merely adapting to the incentives presented to them by our current economic and political system.
In fact, the real question is why so few economic actors indulge in fraud or milking taxpayer guarantees when they have every incentive to. After all, choosing not to play the game means accepting lower returns if one’s a shareholder and accepting lower bonuses and possibly even being fired for underperformance if one’s a manager or a trader.
The answer is that our ethics prevent us from exploiting the situation. But our ethical standards do not remain constant. They can and will erode if a perverse system is in place for too long. This gradual erosion of ethical standards is the real risk we face if we do not reform our system and fix the incentives. We may not realise this until it’s already too late and reversing this process and rebuilding ethical standards and trust in an economic system will be no easy task.