Imagine society as a system composed of four subsystems: the government (governing bodies, democratic procedures, civil rights); the financial system (banks, Wall Street, financial regulators, mortgage companies, personal financial behavior); the health system (hospitals, health insurance, personal health care behavior); and the national security system (military and foreign policy). As the subsystems interact, the structure and behavior of the overall society is in constant flux, evolving in directions that were not necessarily ever planned.
Society is not a static structure; rather, it is a composite of smaller structures, in turn composed of still smaller structures – all in flux. At each level, the interactions are only partially planned by any official, central authority. In addition are a multitude of individual actions.
A new “component” may be created by a Wall Street trader or mortgage company. New components that have contributed to the current financial crisis include:
- High-risk mortgage packages that took multiple high-risk mortgages, then sliced and diced them to generate complicated financial packages Wall Street could sell;
- Credit default swaps, essentially insurance policies issued by Wall Street to “insure” their high-risk mortgage packages but called “swaps” so Wall Street could avoid holding collateral;
- Zero-down mortgages for people who really could not afford the house they were buying.
These new financial instruments will of course affect the rest of the system, though not necessarily in anticipated ways.
For more evidence on mismanagement of the financial system, see Calculated Risk on how the SEC was implementing its regulatory
Similarly, new “links” (e.g.,) arise. New links that have complicated the process of understanding how the financial system now behaves include:
- Pressure from Congressional Democrats on Fannie Mae to back risky mortgages so the poor will have access to houses they could otherwise not afford during a housing bubble;
- Letters originated by Fannie Mae urging potential homeowners to accept “creative” mortgage instruments;
- Wall Street competition with Fannie Mae to back risky mortgages;
- The sale of risky mortgages to foreign banks.
Laws and regulatory procedures to control these new instruments or forms of behavior in the system will probably not exist or be created in a timely fashion. For example:
- Fannie Mae increased the proportion of risky mortgages it was willing to back without accordingly increasing the requirement for collateral backing the mortgages;
- Congress pressured Fannie Mae to back riskier mortgages without accordingly upgrading its oversight;
- Individuals bought “creative,” high-risk mortgages without calculating the long-term commitment they were making;
- Wall Street “insured” credit default swaps without setting aside the high levels of collateral that would have been normal for such risky loans;
- Government (the White House, Congress, and regulatory agencies) failed to create regulations in step with the creation of the new Wall Street financial instruments, such as credit default swaps;
- Banks, U.S. and foreign, failed to understand the level of risk inherent in the high-risk mortgages that they were taking over.
New components, new links, and new procedures (or the lack of them) all contributed to a rapid rise in the complexity of the financial system without a parallel rise in the understanding of those charged with managing it.
Therefore, the system moves out of control, with its various components (other jealous traders or competing banks or home buyers) making their own independent decisions. In other words, the system self-adjusts and evolves into something new and unplanned.
In a large, vigorous industrial society, this endless process of self-adaptation could easily outrun the ability of even the most dedicated, patriotic government to keep up. The system is of course characterized by a multitude of interconnections. But knowing that in theory does not make it possible for any governing authority to keep track of them in practice. As Yaneer Bar-Yam pointed out in his Dynamics of Complex Systems, the amount of information necessary to manage a system can in theory reach the point where no person can know enough to make the proper decisions, and modern society may indeed now have reached this point.
The Soviet Union, with its determination scientifically to control everything, was an extreme example of a system intentionally designed to work only if all details were known and fit into an official plan. The current U.S. financial crisis is an example of the opposite extreme – relying on the invisible hand of the market to generate the right decisions without regulation. As we see, a modern industrial society can easily reach the point where neither approach works.
Beyond the mere fact of a multitude of interconnections, which makes system management enough of a challenge, lurks the subtle threat of the system not just fluctuating out of control but moving consistently in some unforeseen direction, like a swimmer caught in a rip tide. In the current financial crisis, obviously risky behavior (e.g., selling mortgages with less and less security even as the bubble expanded) seems to have been used as the justification by others to copy the process. It is obvious that the fact that others engage in risky behavior in an inherently risky situation (a bubble, by definition, must come to an end) logically compels one to behave in a LESS risky manner in order to hedge against the foreseeable instability in the rest of the system. Nevertheless, greed trumps logic. Similarly, the very violence of Bush’s foreign policy undermined the search for stability: the invasion of Iraq, for example, provoked terrorism and ethnic conflict in that country. In both cases, mismanagement of a very complex system allowed (or provoked, if you prefer) the system to evolve rapidly and steadily in an unforeseen direction.
For details about the links between economics and foreign policy, see
this troubling report on the rapid rise in Chinese dollar holdings.
We either need to pull back from the edge of chaos by simplifying our major social systems or improve our management skills over those systems.