One of the remarkable things about the current crisis in our global financial system is that what it reveals is that no-one really understands how the system works. Certainly there is no shortage of people who purport to know how the system works, of commentators, pundits and of course those that have made unfeasible a amounts of money on the back of their insight. But are all these people trying to tell me that they understood how this system worked but stood on sidelines with their hands in their pockets and a knowing smirk on their faces while the very thing they depended on crashed and burnt around them? That’s why I am saying no-one understands this system because if they did you have to think they would have done something to protect their jobs, their income and their reputations and acted to save it. They didn’t.
An alternative explanation is that lots of people did know how the system works but didn’t care that that it was all going to hell in a handbasket and taking the rest of us with it; in a way that is even more terrifying.
But probably the most likely explanation is that participants in the system only understood their small part of it and the incentives therein and could take no practical responsibility for the system as a whole (even if they wanted to be a force for good).
This inability to see the whole is also defeating the commentators and pundits who all see the part that there are expert in and their solutions are also therefore of limited use.
The most important lens to look at this whole sorry mess through is a systems lens because it provides the clearest guide to effective action. And action is what we desperately need.
The most problematic response is the immediate cry for regulation. Governments need to be seen to be doing something. But regulating at the problem end of the system (for example banning short selling) is only tackling symptoms not causes and is just as likely to create unintended consequences and further problems.
If legislators need to act, and they do, then they can’t act partially as fire-fighters seeking to put out flames when a flare erupts in the system. This makes politicians look like they are at the mercy of events rather than in control of them as they continue to run around with regulatory hosepipes aimed at the next flare-up. This is why, at least in part, the current regulatory regime failed to prevent this crisis from occurring in the first place. In the UK case the FSA kept all it’s fire-engines at the station because it didn’t smell any smoke. We need to learn.
What our policymakers and legislators need to now turn their attention to is the architecture of the system; to do that they need two things to be made clear. Firstly what the purpose of the system is and secondly what systems principles need to be embedded in the architecture to ensure that it is fit for that purpose. The first point is complex for sure especially given what to my mind is the rather sterile pro vs. anti-capitalist arguments filling our media right now; what is clear to me is that we need a financial system that can provide capital in order for the economy to provide goods and services that we need and want. No money, no economy, right? One of the things that has gone wrong is that we have allowed the purpose of the system to become ‘Make Money’ rather than ‘Make Stuff Happen’. This has led to the financialisation of the system where participants end up being able to make more money by trading intangible things like risk and placing bets with each other on future outcomes of financial deals than actually providing a financial service to the economy. The systems purpose needs to be reset. A big job but perfectly possible given that it is a system that is supposed to be serving us not the other way around.
On the second point around principles the following is clear to me. Firstly the financial system was allowed to become highly monocultural as structures within the system copied each other to a dangerous degree. Fortunately some diversity remained (some mutuals still thriving, some big banks not piling into funding their balance sheets on the overnight money markets, many variants of micro-finance etc. etc.). Any system needs diversity if it is to thrive and be resilient to external shocks. Creating and incentivising many different ways of achieving the purpose of the system and mixing things up should be one goal of policymakers.
The next design principle should tackle the problem of over connectedness and mutual dependency; it was this component of the system architecture that has meant that severe problems felt in one part of the system (US sub-prime loans) are quickly able to bring down the whole system. Systems designers should turn their attention to facilitating the creation of a more modular system that allows a level of independence of system components from each other. Such a modular structure would insulate components of the system from each other so that if one component is threatened it doesn’t destabilise the whole.
The final principle should be transparency. One of the key failures to my mind is that no-one really understands the system as a whole as it is currently designed. We are then at the mercy of relatively small actors (US sub-prime incentivised mortgage brokers) bringing the whole system down because no one person or institution could see the system clearly enough to spot the danger (if any institution did actually see it and failed to act we need to applaud their intellectually capacity and fire them for their inaction). Put simply the system needs to be able to see itself. Big job here for regulators who can force a range of reporting and transparency measures onto the system.
In the panic that will follow these events in the coming months we need to test the terms of the arguments and debate not through the lens of political ideology (which for too many reasons to go into here I think is the equivalent of seeking to communicate using a dead language), not through the lens of regulatory action on short term symptoms (like the Fed simply borrowing more money to buy failing structures and run them directly, or banning short selling for a couple of months etc. – as an aside it is really a strong testimony to the need for a system view as we see the UK Chancellor and US Fed officials really struggle to find something that they can actually do that won’t make the problem worse) and not through a ‘it’s all fine business as usual’ lens which the more myopic free-marketeers are presenting as their solution (when these ideologues speak I can always hear J.K. Gabraith’s phrase in my head, he said, ‘ nothing serves power better than a theology that disguises it’s exercise’)
We need to move well beyond the usual ideological arguments rooted as they are in worldviews that aren’t much help to the scale and scope of our current problems; they just make matters worse. We need to learn from this at a systems level. We need to create the conditions through which we can create an architecture for our financial system that places collective service at the heart of its purpose not the enrichment of a few individuals who play the system successfully for private gain without any thought for the collective consequences.