Computer Models and the Global Economic Crash

Anti-Globalism passes along a review in Ars of some recent speculation on the role of interconnected computer models in the global economic crash. "If Ritholtz, Taleb, Mandelbrot, and the rest of the computer modeling and financial engineering naysayers are correct about the big picture, then we really are arguably in the midst a bona fide computer crash. Not an individual computer crash, of course, but a computer crash in the sense of Sun Microsystems' erstwhile marketing slogan, 'the network is the computer.' That is, we have all of these machines in different sectors of the economy, and we've networked all of them together either directly (via an actual network) or indirectly (by using the collective 'output' of machines in one sector as input for the machines in another sector), and like any other computer system the whole thing hums along nicely... up until the point when it doesn't."

Comments

Can somebody 'splain this?

[seanadams.com]

I am not an economist but I have owned a couple businesses and consider myself a reasonably practical person.

I have always believed that the vast majority of today's financial instruments have been invented out of thin air for no reason other than to ultimately ensure the employment of bankers and brokers.

For example, lots of people have a checking account, savings account, credit card, poersonal line of credit, HELOC, brokerage account, and more. I see absolutely no reason why a single account could not offer all those features. The only reason you "need" all that is because the banks created all these funny rules so that they could introduce more and more products and services. This is done so they can charge you more for each of those things, and also to differentiate them from their competitors.

Besides consumer banking, can somebody explain to me why we NEED "commercial paper"? Yes, I've read the wikipedia page and I know how it's used, but I don't understand why it's needed. If you can't make payroll then you're pulling from your credit one way or another - why do we need separate instruments for a 2 week loan versus a longer term loan, or a credit card, or whatever?

And don't even get me started on real estate lending...

It's like freaking starbucks - you can get your banking services just as special as an upside-down triple no foam half calf non fat 160 degree two splenda mocha. But it's one thing for a coffee company to cater to every individual snowflake's desire, and quite another IMHO for something as important as our financial system to become as absurdly complex and fragile as it is.

As for the people who are really benefitting from all this complexity - well, it's only during recession that we all collectively take a good hard look at who's making a contribution to society and who isn't. Unfortunately the powers that be think they can beat a recession by tweaking some rates, stealing from taxpayers, or shuffling money from one hand to the other. That's just going to hurt us more in the long term. We need to clean this shit up now - get rid of unnecessary products and overhead, and let the unproductive companies go bankrupt. Let the UAW strangle themselves to death. Just get it done.

Re:Can somebody 'splain this?

[Anonymous Coward]

We don't need it. But the system made people borrow more than they could.

First it was "minorities" (or rather ACORN's definition of a minority "someone who votes for us") that got suspended rules on borrowing, thanks to the CRA, introduced by one disaster president without teeth, Carter, also known for being the cause of the human rights situation in Iran, and activated by the next disaster president, Clinton.

But the damage that this inevitably caused was seen by many opportunists that were just about everyone. So just about everyone, not just Americans, but Europeans, Arabs, Japanese, Chinese, ... the whole nine yards, was given relaxed loaning standards. Since that money ended up in banks, it could be paid to their investors as intrest.

So why did this system work ? Well mostly the money paid for houses was put in bank deposits. So let's depict the money flow :

bank -> lender -> seller -> bank

This is however not how it looks in the administration. Let's check how the accountants enter this scheme :

bank -> lender
bank : + $loan_amount in future income
              - $loan_amount in money
lender : + $loan_amount in money

lender -> seller
lender : - $loan_amount in money
seller : + $loan_amount in money

seller -> bank
seller : - $loan_amount in money, + (100+x)% * $loan_amount in future income
bank : + $loan_amount in money

So now let's look at the total balance of the banks, in the short term :

+ $loan_amount in future income (slightly more)
- $loan_amount in future liability (slightly less)

Ultimately, however, this is a ponzi scheme, but for society as a whole. Everyone who connects is vulnerable in exactly the same way. Even black gold will provide no release, nor will a "knowledge economy".

As long as the pie constantly grows there is no real problem, as the banks control all money (through association with "government banks", or by simply being those banks). They literally print money, which represents value.

But the system needs an ever increasing input of value, or it falls down. As any ponzi scheme does.

Right now the input of 1 subsystem fell *slightly*. Very, very slightly. Eventually the value input will stop altogether (esp. if "peak oil" theories are right, but if they're wrong that will simply provide a delay).

The system is, as they say, doomed.

*AND* we should destroy anyone who was involved in shortselling any commodity related to loans, they should be prosecuted for making (and winning) the bet that tens of thousands of people would lose their livelihoods, their houses. These people's gains should be impounded, their bets imposed for the total disasters that they were. And all other short-selling should be suspended as too risky to the economy.

Or at the very, very least, banks should be prohibited from loaning money to allow shortselling, and they should be forbidden from using money invested in shortselling practices as collateral for loans.

But we won't do that. If we did, the financial sector would shrink to 10% of it's former size, which would put much less money in Obama's hands to work with. Much, much less. And it will mean telling hundreds of thousands the truth, that they cannot be trusted with enough money to buy a house. Many of them will be "traditional americans", but obviously both the poor and "minorities" will be overrepresented, and won't be able to buy a house. (who are the original spark that started the fire, I do not want to claim it's "their fault", but they are part of the problem)

Re:Can somebody 'splain this?

[hey!]

For example, lots of people have a checking account, savings account, credit card, poersonal line of credit, HELOC, brokerage account, and more. I see absolutely no reason why a single account could not offer all those features.

Neither did advocates of banking deregulation in the 1990s.

One of the reasons for this "redundancy" is (or used to be) that different rules apply to each kind of account. You used to have have commercial banks, investment banks, and insurance companies, and each did something different under different rules. Then the rules that had been in place since the Great Depression were repealed by Gramm-Leach-Bliley, and suddenly the legal boundaries between these kinds of financial services was gone.

Subsequently, we are facing the greatest economic crisis since the Great Depression. Coincidence? I'm not entirely sure, but surely some of the problem is that practices and attitudes that were normal in investment banking suddenly started to crop up in other businesses.

Although Hank Paulson is actually, in my opinion, one of the more decent individuals as a person in the administration, he's very much the wrong man at the wrong time. One of the things he did as head of Goldman Sachs was to convince the SEC to get rid of the "net capital rule". That was the rule that required banks to maintain a certain level of cash on hand to cover cash demands in unusual situations. This is obviously extremely expensive for companies who had to keep huge volumes of cash on hand, losing mind boggling amounts of value even against modest inflation.

Had the rule been kept in place, we might not have had to pony up seven hundred billion dollars to bail out Wall Street.

Re:Can somebody 'splain this?

[kgskgs]

Commercial paper or financial complexity is not the real problem. The real problem is reality. Let me explain.

There were three fishermen in a village. They were not able to do fishing because they lost their nets. One day one of them heard of a fishing net weaver in the neighboring village. So he went and rented a net from the weaver. To pay rent, he borrowed the money from the same weaver. He could go fishing now. The second one found out and he did the same thing. The third one went to rent a net as well. The weaver had only two nets. But he smartly figured out that the three fishermen never go fishing at the same time, so there will always be one net idle. He smartly figured out scheduling algorithm. So also started renting the two nets to three fishermen.

All four were happy. The fishermen always assumed that they will have net whenever required. The weaver was happy to be able to rent two nets to three people.

One fine day the assumptions made in weavers scheduling algorithm broke down and all three fishermen needed the net. They came to realize that there are not really enough nets and sometime they might end up not getting the net. So each fisherman started renting the net for more time than required to avoid the risk. This increased the net renting price (Inflation), also the nets started staying idle for long times (Dropped output). The fishermen could not pay their rent loan installment in time. The weaver started losing money and he could not maintain the nets. Ultimately everyone was poor again.

Nothing changed from start to beginning but everybody's risk perception. Originally, with the false perception of zero risk and abundance of resources was created by the weavers assumptions. This perception broke down and everybody started paying high insurance to avoid the risk and this left little money for investment.

In today's case, the net weaver is the bank and fishermen are consumers.

Do you know what is the biggest difference between developed countries and developing countries /third world? In developed countries people keep less for the rainy day and invest more. In third world, people stack up more for rainy day and invest less.

K

Re:Can somebody 'splain this?

[Gription]

The part I want 'splained is: Why does anyone think that the stock market is a serious indicator of the state of the economy?

These types of exchanges (stocks, commodities, etc...) are Gambling dressed up for high society. That doesn't mean that they aren't reasonable investments over the long haul. Any reasonable person looking at them over the short haul will see that they are driven by everyone trying to guess which way everyone else is going to jump. This is simply gambling.

Everyone knows the market is going to be way up in a few years because it is currently highly undervalued but because the vast majority of investing groups are buying and selling with short term gain in mind the market is bouncing around like a superball. Maybe if someone was required to hold a stock for a minimum period of time it would make stocks an indicator of something.

Off to the side of this:
I really think that the government could free up a huge quantity of the credit blockade by lending directly to the enduser to force the various credit companies to wake up and try to compete for their markets.

Example: Home loans. 30 year fixed rates have usually floated at around 2+% over prime. Now because the mortgage companies wrote unserviceable loans so they could sell them instead of service them, they are all licking their wounds and are currently loaning at 5+% over prime. This works out to a subsidy to the mortgage companies so they can make up for their idiot losses. At the same time no one can sell their house because no one can get credit and if the houses don't move the price drops screwing home owners. At the same time banks are dumping foreclosed homes further driving down the home price comps. (Oh and the banks DO make loans for the houses they are dumping!!!)

If they would just refinance the so called "Toxic debt" mortgages at 3% over prime it would drop the payments down to a point where most of the "toxic" loans would be workable for the debtors and then they wouldn't be toxic. At 3% over prime it would be plenty profitable too. If they would force the mortgage companies to carry the paper on a portion of the loans (selected at random) it would guarantee that they wouldn't write fraudulent loans either...

(now get off soapbox...)

Re:Can somebody 'splain this?

[Lumpy]

Which is why I will never EVER become Incorporated. I prefer honesty and doing things right.

What you say makes ZERO sense. I'm not having "tough times" right now. In fact I have CASH and am sucking up lots of gear being auctioned by my competitors at $0.10 on the dollar. I recently got a $4800.00 Beta cartoni tripod for $500.00 at a Grand Rapids business auction.

Sounds like I'm doing it the right way and all my competitors are not.

Re:pointing fingers

[AJWM]

Two words: "emergent behaviour".

No one group of programmers programmed all these computers, there was no single set of specs for the whole network. All the components may well be "functioning exactly as they should be" (although in reality I'm sure there are a few bugs in the systems, but that's irrelevant here), but the system overall may behave in an unexpected way.

(That said, I don't think that's the whole problem either -- too many people playing a bit fast and loose and less than honestly with other people's money is also part of the problem.)

Re:pointing fingers

[BigTom]

What is tightly regulated? Half the Quant algo trading models get thought up in the evening, coded overnight and activated in the market the next morning.

If you try and slow them down they just run to the head of the desk bleating that the "nasty IT man stopped me making $1000,000,000 for the bank with his silly QA nonsense" and whoosh, its in production. It is prop trading so its their risk.

Can't model in human traits

[HW_Hack]

How can you model in greed - corruption - and the ever popular human trait of freaking out ?

Tech bubble - Real Estate bubble ... next time I even see/hear the word bubble in the markets I'm cashing out for a while

Does the argument support the conclusion?

[MoellerPlesset2]

Seems to me the author is repeating the mistake himself: By drawing a conclusion not supported by the data, in this case being the evaluation of the role played by computer models here.

And I agree with that datas: The problem isn't the computer/mathematical models. It's how they were used. In particular, people were using models designed to evaluate one kind of mortgage asset, and plugging in an entirely different kind of mortgage, etc.

The author grants that conclusion, but then makes the claim that although the problem wasn't caused by the computers themselves, that it was somehow exasperated by them. - I don't see how that's the case.

Computers and computer modelling makes it easier to create advanced derivatives and such. But it doesn't make us do it. Just look at the engineering world; We don't choose technically advanced solution just because we can. In fact, the tendency is to go for the simplest possible solution. ("KISS rule")

There's only one reason why you would create advanced, incomprehensible derivative structures: To con people, essentially. To obfuscate the risks. To create money out of nothing. (the most profitable way to make it)

That's not a new problem. There's a reason we created financial regulations, why we have book-keeping, demand financial transparency, auditing, etc. This happened because it was allowed to happen. Because nobody stepped in and stopped this obfuscation from happening. I don't blame the computer models. If someone cons you into signing a bogus, misleading contract - the problem isn't with the paper it was written on or the language that was used. The problem is with the law allowing such contracts to have legal force (which is a regulatory problem from another century).

To extend that analogy, this is a bit like standing in that situation and asking whether or not written contracts are a bad thing, and whether we shouldn't go back to simpler, oral contracts. The bottom line is: As long as it's profitable, there will always be people trying to obfuscate and hide information for economic gain, and there will always be a need for regulation and oversight to stop people from doing that. But blaming the methods by which it's done is pointless.

The model assumptions were ideological

[grandpa-geek]

There are two equally valid descriptions of markets. One is by Adam Smith, with the "unseen hand" guiding the markets. Smith markets are well behaved, efficient, and amenable to analysis by what amount to small-signal statistics.

The other description is by Charles Mackay in his book "Extraordinary Popular Delusions and the Madness of Crowds." In that book he describes the Dutch tulip craze and other bubbles in history prior to the mid 1800's. This economic crash is more of the same.

The models, probably because of "free market" ideology, assume a market where Adam Smith's "unseen hand" is at work. The modelers don't consider the kinds of markets described by Charles Mackay. Most of the models are based on the Black-Scholes option pricing theory. If you look at the assumptions underlying that theory, they describe good behavior, efficiency, and changes describable by what amount to small-signal statistics.

Mackay markets are boom and bust, with greed and lies and herd behavior all around. That's what we had. The underlying mathematics has been studied, but not for markets. If you have a pre-LCD TV, an electronic circuit that is non-statistical but related to boom-and-bust market behavior creates the sawtooth sweeps that paint the picture onto your screen.