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?

[cbiltcliffe]

It's easily explained by the Golden Rule:

He who has the gold makes the rules.

There. Explained.

Re:Can somebody 'splain this?

[Anonymous Coward]

It all goes back to the "invisible fist" of the free market...

Re:Can somebody 'splain this?

[Z34107]

I am also not a financial expert, but I can see a bunch of reasons why financial paper exists.

Maybe they're like payday loans for corporations. You have a long-term contract due, but not 'till the end of the month, and you want to keep your employees in the meantime. (I'm guessing this isn't as likely; only corporations with outstanding credit ratings can actually have any success in issuing corporate paper.)

Maybe it's a way of getting a loan without going through a bank or issuing stock. Say you want to build a new factory with payroll rather than actually pay your employees; maybe you're assuming the factory will pay off the interest on the corporate paper and then some.

The biggest thing at the end of the Wikipedia article you read is that, whatever the reason the money is needed, it's cheaper than getting it from a bank. If a corporation is big enough and has good enough credit, they can issue corporate paper, at a lower interest rate, instead of paying interest to a bank.

So, that one, at least, wasn't invented by bankers just to secure their own employment. Maybe somebody who actually knows something about this (a banker, maybe?) could enlighten me.

Re:Can somebody 'splain this?

[2nd Post!]

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.

Actually, probably not. I suspect (I'm a programmer by nature, so my experience with code may apply here) it's more of each institution and "network" offering redundant services until multiple institutions mature to the point where these services collide and become confusing.

For example, lots of people have a checking account, savings account, credit card, personal line of credit, HELOC, brokerage account, and more.

That wasn't true one generation ago. My parents had only a checking acount, savings account, and credit card.

I see absolutely no reason why a single account could not offer all those features.

With the advent of computers and networks, now it is possible. But 20 years ago? Not possible.

How would a bank know how much equity you had in your house? How would your credit card company know how much you had in the bank? How would your mortgage company know what your investment amount was?

Today, you actually have one company that handles all of it (and in cases where they don't, they can still trade information). So now I can have a HELOC, personal line of credit, credit card, savings account, etc, all tied together, in that credit from one reduces the amount of credit available on another, and all paid from the same account.

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.

In this case I actually disagree. Different people have different had different "collateral", so different kinds of credit were available to them. That explains why different products exist. Someone with a house vs someone with a strong credit rating vs someone who had lots of money all had access to different products. Now a single person has access to all of them.

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?

As before, commercial paper was "invented" before credit cards (or business lines of credit or whatever) existed. It satisfied a market need that probably doesn't exist today.

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.

It's this statement that brought me to this answer. Software is flexible (soft), so it can be molded quite easily to different needs according to different usages. The problem is that after four versions needs have evolved, but the original code has not, so now you have something complex and fragile that was originally quite simple and straightforward.

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.

So like software, it's only

Re:Can somebody 'splain this?

[uncreativeslashnick]

Most of it is the way it is because it evolved that way, and because of the laws/rules under which it all evolved. You paint with too broad a brush when you say that the vast majority of today's financial instruments have been created out of thin air. That's nonsense spoken out of ignorance, the same way a non-geek might say, "why can't software designers create programs without bugs?"

Commercial paper is a very broad term and encompasses everything from promissory notes to normal consumer checks. Just about any transaction not involving cash or electronic transfer is done with commercial paper. A huge portion of financial transactions are still done with commercial paper. So in the general sense of the term, it is still very, very necessary.

Now if you want to start examining specific financial instruments, like the derivatives backed by (partially) crap mortgages, we can have a conversation. I think the idea behind those instruments was basically sound, but the things ended up being a lot more complicated than people thought. It makes sense that if you lump a bunch of mortgages together, only a small percentage of those will default, thereby distributing your risk. But in a climate where fraud was rampant and the people signing people up for mortgages had no incentive to make sure people could actually pay those mortgages back, your lump of mortgages has a much higher chance of containing too many bad mortgages to make the resulting instrument profitable.

The derivatives market had the perverse effect of creating and encouraging that climate, because the mortgage buyers would buy without enough questions because they knew there were buyers who would buy the derivatives without too many questions. The fundamental problem with the whole concept, it seems to me, is that the derivative buyers and sellers forgot to insist on and question the credentials of the individual mortgagees they were investing in. Had they done a little bit of verification there, we might not be in this place right now.

Re:Can somebody 'splain this?

[DNS-and-BIND]

Cash in the bank is money sitting idle. You want your money out there, earning for you. If you choose an overly conservative strategy where you don't borrow money, then your business isn't running efficiently. I assume you're an owner...in a corporation, you would be subject to lawsuits and removal if you are not getting the shareholders the maximum benefits available. Remember, a CEO's goal (lawful duty, actually) isn't to make a profit, it's to maximize profit.

Re:Can somebody 'splain this?

[HisMother]

This bullshit is exactly what's wrong with our entire capitalist system.

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?

[SerpentMage]

Oh come on...

Here is a question do you have a mortgage or did you pay for your house UPFRONT?

What about a car? Pay for all of it upfront?

I am not saying over leverage yourself, but to say companies and businesses don't need credit is completely fool hardy.

Credit is needed in a system where you are able to make purchases in certain items. The problem is when people over leverage themselves.

Re:Can somebody 'splain this?

[AlXtreme]

Credit is needed in a system where you are able to make purchases in certain items. The problem is when people over leverage themselves.

And that is exactly what happened. Both businesses and consumers were overleveraged, the realestate bubble burst and the whole cardhouse came crashing down.

Personally I don't see why you would need credit to buy a car though. If you don't have the cash don't buy a new car, get a second-hand one. Cars are a worthless investment, especially new ones. My rule of thumb is to only use credit if you are making an investment that has a very good chance of at least keeping its value.

Homes on the other hand... oh wait, never mind...

(but seriously, even in this market a house will still have considerable value after 10 years, where a car will be close to worthless)

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?

[Estanislao Mart�nez]

Instead of doing Shady and immoral accounting practices why not do what honest small business do. YOU HAVE THE CASH ON HAND TO PAY YOUR BILLS.

Because once a business gets large enough, the cash flow becomes enormously more complex, and very short term credit becomes a cost-effective way of managing cash flow.

Basically, a business wants to match cash inflows with outflows (and to simplify the model, we'll count "profits" as one of the outflows). The problem is when you know that your business is owed cash that's going to arrive in unpredictable payments over the next 30-90 days. Setting up the cash outflows so that they precisely match the inflows becomes hellishly more complex when the number of transactions gets big enough. Short term debt provides a buffer that allows a business to simplify this.

In principle, yes, a business could do the same thing by keeping cash reserves as a buffer, too. But when you take into account the time value of money, that really comes down to the same thing: by keeping cash, the business implicitly pays the opportunity cost of keeping that cash. (And with an inflationary monetary policy, of course, the cash itself becomes less valuable over time.)

So, to sum up, the money owed to the business over the short terms is its accounts receivable; short-term debt allows a business to convert, for a fee, a large fraction of its accounts receivable into cash, and therefore, to draw upon its accounts receivable to finance its operations. I.e., instead of having n dollars of pure, unencumbered cash at its disposal at any one time, it can have n + ((accounts_receivable * reliable_fraction_of_a_r) - interest_on_short_term_debt)); or, equivalently, to keep less unencumbered cash than it would otherwise need to.

Re:Can somebody 'splain this?

[Spasemunki]

...,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)

This whole post is total bullshit. The notion that, somehow, attempts to counter historic discrimination against blacks and other minorities set off the economic crisis is just foolish. The regulations imposed on certain banks were very modest, and were essentially designed to prevent worthy borrowers from being denied due to where their house was located ("redlining"). Nothing in the CRA requires banks to extend loans to people who can't pay them back. Most of the banks that were hit hardest by the mortgage crises weren't even subject to the CRA, because they weren't commercial banks. Yet the whiners in the pundit class persist in arguing that armies of poor people strong-armed poor, defenseless banks into making bad sub-prime loans. Never mind the studies that have shown that CRA-regulated banks were less likely to make subprime loans, and less likely to re-sell their loans. Never mind the fact that only one in four sub-prime loans originated from a CRA-regulated bank. Yep... poor people. The secret masters of our economy.

And Jimmy Carter? He might have been a tool of a president, but blaming him for Iran is bizarre. Horrible policy making in the region going back to WWII sunk Iran. Jimmy was just lucky enough to be there when the music stopped.

Re:Can somebody 'splain this?

[Red Flayer]

Your understanding of accounting is way off (and so you shouldn't claim to speak for accountants when you write that gibberish).

Also there are a few uncertain assumptions in your little 'analysis' -- one, that the seller chooses to reinvest his sale profits with the bank. You claim that most cash proceeds from the sale of houses was deposited in banks -- this is false. Most was actually reinvested in other real property or elsewhere.

Plus, you ignore the opportunity cost of the funds the bank is due and the risk of default (hence the interest rate on the loan).

I know the banking industry has its problems, but claiming it's a ponzi scheme is just uneducated. The banking system is NOT dependent on influx of new investors to pay their creditors (leaving a gaping cash hole when new investors stop appearing). They are dependent on the stream of payments from existing debtors. When that stream dries up, their ability to lend dries up, since they become cash-flow negative, and eventually have no capital to lend.

The problem is that the banks are unwilling to lend when the expected return on their capital outlay is negative. Due to the fluxed up state of the economy, banks in general have decided that lending is unwise, since the risk of default is so high. The big problem is that banks did not properly assign risk to certain loans, so that they undercharged on the interest rate. The reason this slightly relates to a Ponzi scheme, is that as long as another bank was willing to underwrite a risky loan, then bank could get rid of its risk when the property in question was sold. It was a game of hot potato -- whoever was left holding the risky loan when everyone stopped lending lost. And the big problem was that it continued for too long -- eventually the amount of risky loans was so large that almost *everyone* was left holding a sack of hot potatoes. If credit rules had been tightened, rather than loosened, then a few banks would have gotten burnt early, and the problem would not have spiraled.

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:Can somebody 'splain this?

[johnsonav]

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

If you're looking to the stock market as a barometer, you're in for a let down. The price of a stock depends on so much more than just the state of the economy. The only real rule is: historically high stock prices usually indicate overconfidence, and historically low stock prices usually indicate undue pessimism.

Everyone knows the market is going to be way up in a few years because it is currently highly undervalued...

You sound like the prognosticators in 1929. But it took 22 long years for the Dow to surpass its pre-depression highs. Don't commit the same sin of hubris that got us here in the first place.

Maybe if someone was required to hold a stock for a minimum period of time it would make stocks an indicator of something.

But that would remove one of the main reasons to own stocks, their liquidity. We don't need stocks to be an indicator of anything at all. All they represent is the value the market places on projected earnings.

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.

Now here's where you lost me. You think that banks are going to try and compete with the government, which can borrow money to lend at almost zero cost. Banks have to get their money from somewhere, and their risk of default is seen as so much higher than the government's, that the interest rates they can borrow at are sky high right now. Why would they try to compete with the government at all? They're almost guaranteed to lose.

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...

I think you underestimate the scale of the mortgage problem. There is too much debt out there on homes that are worth nowhere near what is owed. What incentive does the homeowner have to repay a loan when they are $100,000 underwater? Even at a zero percent interest rate, it just doesn't make sense for the borrower. Those toxic loans are called "toxic" because there's really no good way to fix them.

Re:Can somebody 'splain this?

[billcopc]

Banks have to get their money from somewhere

No, they don't.

Fractional reserve is the root of our problems today. The system is designed to lend out more money than actually exists, thus the economy is overloaded by design, and inflation is guaranteed.

Well I don't know about you, but I'm pretty sure them cows don't produce 3% more milk with each passing year, nor do they yield 3% more meat. You can say what you want about wealth, but there is a fixed amount of natural, life-sustaining resources in the world, and printing more money isn't going to change that.

Re:Can somebody 'splain this?

[Captain Nitpick]

Well I don't know about you, but I'm pretty sure them cows don't produce 3% more milk with each passing year, nor do they yield 3% more meat. You can say what you want about wealth, but there is a fixed amount of natural, life-sustaining resources in the world, and printing more money isn't going to change that.

Wrong. The cows do, in fact, produce more milk every year (not the individual cow, but the average cow). More importantly the dairy industry becomes more efficient every year, making it possible to have more cows using fewer resources..

"The greatest shortcoming of the human race is our inability to understand the exponential function." -- Albert Bartlett

Production and efficiency in a single industry can only increase for so long before the results become absurd or impossible.

The average dairy cow in the US produces ~20,000 pounds of milk annually (rounded for simplicity). If we pretend we can get 3% improvements annually, then after 100 years we'll have nineteen times the milk we started with. At the end of 200 years, each cow is producing a pound of milk every four and a quarter seconds. In 300 years, 4.5 pounds/second. You'd have to stick a pipe down its throat just to prevent dehydration.

And as far as more cows using fewer resources goes, you run up against basic physics. Calories in >= calories out. Efficiency improvement is constrained by the universe.

Re:Can somebody 'splain this?

[Abcd1234]

They don't loan out more money than they receive as deposits.

Actually, they do. In most modern fiat currency models, banks must hold a minimum reserve relative to the amount of loans they give out, but can otherwise issue loans up to that ratio.

In fact, banks quite literally create money by making these loans, which is how the US money supply grows (and is one of the reasons why adjusting the interest rate affects inflation... if you reduce the rate at which loans are granted, you reduce the rate the money supply grows, which translates to lower inflation). It's actually a pretty fascinating, if confusing, topic. I'd recommend reading up on it!

The source of the problem

[Anonymous Coward]

has nothing to do with computers. The source of the problem is the source of money. Who decides how much money there is? Who reaps the benefits of creating money which is not backed by real productivity? If you're truly looking for the root of the problem instead of symptoms, then you have to find out about the inner workings of the money system. In other news, the "Federal" "Reserve" bank has once more lowered the interest rate. The dollar is now less than 0.25% away from being free (i.o.w. worthless) money.

Economics models are like goat entrails predict...

[tg123]

Economics models are like using goat entrails to predict the future so this wouldn't surprise me. sorry just had to put my 2 bits in

pointing fingers

[girlintraining]

I'd just like to point out the bleedingly obvious: That people programmed these computers. They are functioning exactly as they should be. If they weren't, we'd have heard about it by now. So the problem is not the computers, or the network, but rather the people who control them. Thank you. You may now resume your regular ranting, already in progress.

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.

Re:pointing fingers

[Znork]

Considering the fundamental basis of the whole system is based on the flawed assumption that credit can be infinitely expanded the current failure is hardly surprising. The Austrian school pointed out the fallacies that caused both the last depression and the current one almost a hundred years ago.

Computers have very little to do with it. Constructing models to fit political economics rather than to reflect reality is closer to the actual problem.

Re:pointing fingers

[DragonWriter]

Two words: "emergent behaviour".

Its not emergent behavior of computer systems. Its the exact same kind of behavior markets have displayed without computers.

Sure, things haven't been this bad recently, so some elements of it are new, at least in the short term, and the details change always. But none of the big picture stuff has much to do with computers, fundamentally. Economic markets are vastly interconnected because their substantive outputs and inputs (not just data outputs and inputs of the computer systems currently used as tools in managing them) are directly linked.

Blaming computers is about as justified as blaming witches.

Re:pointing fingers

[girlintraining]

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.

There's a bug in Internet Explorer. That must mean the entire internet is broken. No. Financial transaction systems are heavily audited, rigorously tested, and subjected to heavy regulation. They are the most hardened systems in wide use in the commercial sector. Period. That doesn't mean there aren't problems, but a problem big enough to cause a network-wide malfunction are very, very low.

What we're dealing with now are people who made bad assumptions about the economy, got cocky, and now we all are paying the price for the lack of oversight and auditing done on the decision-makers responsible. Looking for simple solutions (ie, "the computer did it") to complex problems is naive at best. This took many several thousand people, all making the same bad decisions, to bring us to where we are now. I will say it again -- this is not a technological failure, it's a failure of people. And if you ask me, we should start publishing the "bugs" -- ie, the names and faces of these people, so the rest of us know to never let them anywhere near the financial sector ever again.

But that would just be too easy.

Re:pointing fingers

[BigTom]

The plumbing is not the problem here. It is the Quant models that _are_ the market in many cases (certainly where ever hedge funds are significant players).

Understand the System Dymanics of Emergence

[Anonymous Coward]

It is not just the computers, but the humans as well. The entire interconnected system of humans and computers in one planetary collective. A planetary economic dynamical system emerges from this, and takes on a life and behavior of its own, including organizing itself towards a "self-organized criticality" state that would eventually avalanche as it is doing so now.

The system grew far faster than it's underlying resources would allow for, ultimately driving it to a point of exhaustion and shock, leading directly to a cascade of failures spreading around the globe to nearly all segments of the market. It was inevitable, and I saw it coming many years ago, though I could not predict when it would transpire.

It's kinda like earthquakes. You can see the tension between the tectonic plates building up, but you can never be sure when that pressure will release itself. So it goes with the global financial marketplace.

Many parts of this market is zero-sum, yet predicated on the fallacy of "infinite-growth". You cannot have it both ways, my friends. It must fail, and that can "easily" be shown mathematically.

And so my "Greater Fools" theory of the market stands. If you hold a stake in it, your only hope is to find a "greater fool" than yourself to take it off your hands at a higher price. Since the supply of fools are finite, and the resources they hold are also finite, someone *must* be left holding the bag, due to the zero-sum dynamics of the market.

Computers being in the mix only make the shocks more severe and dramatic; but the same applies regardless.

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.

Taleb's explanation of the Narrative Fallacy

[icke]

http://en.wikipedia.org/wiki/Nassim_Taleb "Narrative fallacy: creating a story post-hoc so that an event will seem to have an identifiable cause."

Don't blame the computers

[deodiaus2]

There are lots of problems in the financial system that have nothing to do with computers. If anything, computers have brought these problems to light.
You see a lot of this pointed out on Jim Cramer's show "Mad Money", http://madmoney.cnbc.com/
Most of our problems have to do with the lack of transparency in financial systems on supposedly public traded companies. As Cramer pointed out, "How can you have these levels of fiction after Sarbone-Oxley?" Moreover, with the recent Ponzi scheme uncovered, it makes you wonder just how interested is the SEC in maintaining the integrity of the financial system? That and allowing the short sellers to destroy the banks, leaving the tax payer to bail out the investors in order to preserve the financial system.
Thank god, we have the best form of government money can buy. Unfortunately, it even works to preserve the status quo when the original players are bankrupt. Nothing new here, after all, Japan's emperor was able to maintain control long after he had been defeated.
I am sure the US empire will survive this minor setback. The Hessian empire was bankrupt for hundreds of years before it ultimately collapsed. Maybe we can drag this on until the next Ice Age or until we poison all life to extinction, so who cares about the messes in the meantime?