Guest Post: How a Systems Perspective Can Help Financial Reform

With the financial system on the exam table, it has been more than a bit troubling, that certain questions are neglected in serious academic/policy debates.

The discussion of possible remedies focuses on regulatory solutions, everything from requiring mortgage brokers to be licensed to increasing financial institution capital requirements and having much greater harmonisation, as the Brtis like to put it, of banking and brokerage firm oversight.

While these measures individually and collectively could be salutary, no one seems to be willing to consider the fundamental question: did the push to facilitate the free flow of capital, both domestically and across borders, play a role in this crisis? For the last 15+ years, the push in policy has been towards increased efficiency, which means lower transaction costs, less supervision, little interest in considering whether so-called innovations benefit anyone beyond their purveyors ( that, “A lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.”).

It’s important to examine this question, because many in this society have come to believe that regulation is bad and ever to be avoided. Yet markets like the equities markets, where participants trade an ambiguous promise anonymously, depend on regulation. Thus, the question should be, “What level of regulation is optimal?” rather than “How much regulation can we eliminate?” The problem with the latter approach is that it can take years for problems to develop, and when they do show up, since the tools to stop them have been thrown away, a full blow crisis has to develop for corrective measures to be implemented.

One perspective on this issue that has generally been given short shrift is thinking about the financial system as a system and looking for lessons and analogies outside the realm of money.

Reader Richard Kline has been pondering this issue in a series of posts (see here, here, here and here) from a complex systems perspective rather than the traditional finance/markets vantage point. The discussion below summarizes his argument; a fuller treatment can be found .

In this post, Kline addresses possible solutions. As you will see, viewing the problem from a different axis leads to some fresh observations (some run the risk of eliciting outrage) that will hopefully stimulate thinking and comment.

From Richard Kline:

In speaking of ‘remedies’ for financial system instability or outright speculative excess, the images which come to mind are regulators in tired suits and thick spectacles, and statutory limits and penalties hidebound in Moroccan. To be sure, the financial systems needs such hard limits. Fundamental contributory factors to the present financial crisis include insufficient and imprudent capital reserves and excessive leverage. Both factors are directly contributory to every bubble you will ever research, are known as such, and act in wholly linear fashions. Harder and higher statutory and administrative limits including mandatory public oversight of capital and exposure are required because participants simply won’t act with restraint without regulation; we see it now as we have seen it time and again.

Beyond this, in systems in general, and the financial system as a specific example, high connectivity is associated with undampened propagation, massive correlation across nodes, and tight couplings between subsystems. All these outcomes are known to diminish systemic stability through cascade effects. Cascades can certainly be limited by outright compartmentalization such that portions of the system communicate through overtly controlled ‘gates.’ This is highly inefficient however, and moreover difficult to achieve in the case of the financial system which is highly fragmented into many nodes. Soft compartmentalization may be more effective, especially through constraints which scale.

In systems in general, self-modulation is evidently associated with throughput overshoots of nodal capacity, and potentially of systemic capacity. Hard limits on the volume of throughput are again inefficient, and moreover will be hard to enforce in the global financial system. Concentrations of throughput—capital, debt, and risk—need to be closely monitored, but systemic connectivity must be considered in tandem due to its capacity to shift stress from system locations of obvious concentration. In general, interventions which serve as ‘capacitors and resistors’ to throughput may have the largest potential value.

Financial markets do have a history of developing effective ‘prudent practices’ which require no centralized intervention. Good examples are margin calls, asset diversification, and subsidiary liability firewalls. These examples: a) all apply at the point of exposure concentration; b) are locally triggered rather than centrally activated; c) require offsetting action without mandating investment purchase or sale; d) generate a verifiable (and certifiable) paper trail, or should; e) residually promote system stability through braking exposure concentration, which to a degree forces differentiation and hence discorrelation. By no means all structural remedies can fit this profile, but together they suggest an optimum design where applicable. The following are several broad concepts of how to implement controls in a many node system, from which specific policies could be drawn.

Dynamic constraints: The optimal form of a ‘control’ in the financial system would be trend active, threshold passive, and nodally focused. That is, when some variable of local concentration reaches a pre-set level, say the volume of a certain asset held, or the shift in value of a certain obligation, a mandatory adjustment is initiated. The thermocouple in your thermostat does this: it automatically trips off, and should you disagree you must overtly act to override the setting. A margin call or a stop-loss sell order both function in this way. In principle, many financial practices are made to look like this, such as mark to market accounting or regulatory reserve capital; in practice, those with the open position have considerable practical discretion regarding when to act, i.e. they are not tightly coupled to re-set. Implementation must be formally automatic, with any steps to delay or cancel being overt and subject to approval.

Now, hard sudden braking at a threshold can be disruptive, both locally and systemicaly; this is why those lending on a margin may be understandably reluctant to call, or slow to act. The solution to this is two-fold: a) more frequent but initially smaller restraints which, however, b) scale progressively larger. Thus, for example, loss reserves should not just increase proportionately at large intervals but rather increase exponentially but gradually over shorter intervals. Leverage may be high for small volumes, but scale down exponentially against large volumes. The onset of a dynamic constrain best acts more as a warning than a brake, but it should promptly build to more a brake than a warning.

Modulate flows: Modulation of throughput rather than outright barriers offers a high return of effect for a low investment of cause. However, interventions must counter-trend. For example, the more money lent or borrowed for involvement in a single market, the higher the interest rate should be for successive increments. This acts against maximum profit, and so seems counterintuitive; however, this also acts against concentration of loss in one node, and correlation of risk in one type. This is ‘inefficient’ but more stable: notice the direct relationship between those conditions. As another example, the larger a position, the less one may hedge (or insure) it and the more one must reserve it. The more of a specific product one moves, the greater the duration between further offers of set volumes of the same. Modulation can be scaled back in a like fashion. Actions to modulate flows can apply node by node, but these also can be used at the macro level by central banking institutions or clearinghouses of various kinds. The point of modulation is less to bar actions outright since ‘the perfect level’ or risk/reward is often ambiguous—or shifts. Rather, the goal is to circumvent faulty guessing about perfection and instead raise costs and lower velocity steadily to dissuade further involvement (and the reverse on the downswing).

Scale flows: Research with many biological systems indicates that they maintain overall stability by power-scaling structures of common form but varying size, often by quarter-power exponents. The applications of these findings need wider consideration for financial system nodes and flows, but two observations serve here: a) restraints on flows must scale exponentially and progressively rather than as now proportionately and abruptly, as mentioned above; b) different levels of constraint should apply at different levels of the system. For example, after adjusting for risk the same interest rates in principle apply to ibanks and used car purchasers. Power scaling implies that participants of smaller scales should be able to borrow more cheaply than those of large scales. There is secondary evidence which implies this in that small borrowing is known to better stimulate overall demand while large borrowing manifestly concentrates risk. Again, small investors can concentrate everything in a single asset without risking system stability, while this is less true of very large investors.

The takeaway on scaling flows and stability is that the larger the concentration of capital the more it should face higher costs and constraints whereas at present the reverse is true. This is a major reason why open capital systems are inherently unstable: they scale the wrong way.

Dis-correlation: Large concentrations of capital concentrate risk. They also tend to correlate investment. They have maximal connectivity on the whole, and so propagate those risk factors systemically more than do smaller nodes. They are minimally adaptive to systemic change. If they cannot necessarily achieve outright monopolies—a Bad Thing unless closely regulated, and often even then—they have the potential to squeeze prices. Moreover, few large participants are more likely to distort flows or markets, though self-correlation alone if not outright collusion. When truly large, they create node-dependency within the system. It is difficult to find a single countervailing positive for large capital concentrations, let alone an offsetting advantage set.

Market de-concentration needs to be strictly enforced, both by market participants and by overt regulation, if markets and the financial system as a whole are to retain ongoing stability; this cannot be over-stressed. Firm sizes, market share limits, asset concentration, and the like all require monitoring and strict caps. Current large players will hate this, but we all need it. Where large concentrations of capital are needed, syndication can serve quite well. Syndicates are likely to be slower to move, and are special purpose rather than ongoing: these are desirable outcomes for system stability, features not bugs. In a nutshell, empires are bad, city-states good (or at least less bad).

Mid-term counter-cyclical restraints: Modern macroeconomic flows are profoundly pro-cyclical, as several commentators have argued. Investor-speculators are too loose and liquid on the upswing and too tight and sticky on the downswing. Prolonged expansions tend very much to concentrate investment and cumulate risk; both developments have undesirable outcomes. In principle, central banks act counter-cyclically, but in practice they are successfully pressured to be slow and timid on the upswing, and fast and reckless on the downswing; i.e. they partially correlate with pro-cyclical movements even when acting against them. Moreover, central banks have discretion to act, can get it wrong, and are inordinately swayed by exogenous impacts; in consequence of these distortions, they typically act too late.

Beyond this, markets which optimize for short-term outcomes may be inherently exposed to mid-term divergences, and so optimize themselves away from long-term stability. Bankers, central and otherwise, famously do not optimize for the long-term. What is to be done, went the famous question?

It is too little understood that systems which oscillate are stable systems; put another way, the financial system can ‘expand’ continuously or it can be stable but not both. One remedy, imperfect but impactive, would be for macroeconomic policy to adopt the same schema of dynamic constraint suggested above: trend-active, threshold passive, scale to exposure, overt override. Small but certain and regular increases in top tier interest rates, mandated reserve increases, and required deconcentration begin with every upswing. The same reverse with every downswing. Central bankers and other regulators if they certify the need (a brake on too ready intervention) can act to stay or accelerate such trajectories—but not to reverse them. Some flexibility in timing would likely be desirable, but not much. Exogenous events will produce salient changes in trend, and one might leave a ‘declared emergency’ option to respond to abrupt trend reversals—but only by moderate increments. Markets and investors would have a clear profile of forward macroeconomic intentions. Turning points are not clear, and there is no perfect formula for this. Perhaps such an ‘invisible governor’ could skip an increment if the inputs are unclear, but must re-set one way or the other on the next re-set term. The advantage of this approach is that it can be driven by logistic trend deflection points in flows, concentrations, correlations, and duration of trend against historical norms which are typically evident before severe asymmetries have time to develop.

Such a concept again seems counterintuitive; central bankers are ‘supposed to act.’ The evidence is that they tend to miss the mark, and that in attempting to support the impossible—permanent expansion—they act irrationally against system stability time and again. Dynamic counter-cyclical action can act gradually where at present central bankers and political actors can’t bring themselves to act. There is the lesser implication that official rates should move away from quarter or half point intervals to decimal ones which have finer resolution, but which through greater variability may serve as a moderate constraint on financial market anticipation.

Compel savings: All debt and no savings means that there’s Hell to pay; call it Faustian capitalism. So how to induce savings? Requiring everyone to pay into a 401k builds better brokers’ bonuses but delivers rather less than advertised over the long-term. Moreover, this actively hurts banks, and inflates ‘liquidity’ in a way that is likely systemically destabilizing. Besides, large net worth participants don’t save anyway: they invest, i.e. more money in motion where less may be ‘more better.’ Further, the investor class cannot be induced to put their money into social needs voluntarily, especially those with long time frames, such as infrastructure, education, and low income housing.

It is time to consider the return of the forced loan. Above a set level of taxes, further premia should be assessed against income and gains where money is borrowed at nominal interest rates and repaid at or over a set term. Payees having the option to roll over their funds, perhaps with a tax incentive. This should start with high net worth, but eventually directed loans should be assessed against all earners in some amounts; whether to apply this to businesses is debatable. Developed in antiquity, the forced loan was a favorite of pre-banking societies; it’s principal use was to finance warfare, an admittedly bad precedent which should be specifically barred by statute. Furthermore, government falls in love with income sources, and revenue flows grow constituencies, so care needs to be given to the destination of such capital. Most certainly directed loans should be partitioned from general fund expenses.

Bonded sovereign debt has a critical function in the capital markets; no new scheme should replace a significant role for public debt. Directed loans cannot ‘replace’ taxes anymore than debt can replace revenue. They can serve to finance long-term, low risk social needs rather than borrowing on the capital markets at higher cost. More importantly, directed lending may serve to shift some societal capital away from speculation at the high end and consumption in the great fat middle into capitalizing the social and financial systems indirectly. This concept needs more development than it will receive here, but it can promote system stability while having some individual benefit.

Relational models: Discussions of the financial system are relentlessly cause and effect in reference. However, cause and effect does not operate the same way in systemic relationships . . . It is more accurate to speak of modulation, catalysis and emergence. Inappropriate conceptualization reliably yields poorly fitting analysis and false conclusions. Much of current macro-economic reasoning is defective because it is overly concerned with lower dimensional supply and demand factors rather than inherently higher dimensional systemic flow and concentration factors; more accurately such reasoning is only locally effective, not globally (in both the figurative and literal senses). This is why we presently see neoliberal macroeconomists inside the Fed and out jamming away at the ‘demand stimulus’ button on their adding machines with puzzled looks on their faces while nothing happens where they are but the system shorts out elsewhere (presently behind the NYMEX panel). If and as economists use models, we need to see more of long-running relational models (that is a technical term) and less of short run linear models. This should be a focus of government level statistical research.

And while we’re at it, good models need good statistics. Going forward, it would be better to concentrate the compilation of critical statistics away from regulatory agencies and Executive control specifically and toward neutral agencies without larger policy briefs. The GAO and even more the Comptroller of the Currency come to mind. No remedy will do much good if it’s cut with baby laxative while someone’s thumb is on the scale.

James H. Brown, ed. 2000. Scaling Laws in Biology.
John H. Bodley. 2003. The Power of Scale: A Global History Approach.

[The papers in Brown’s collection have important implications for systemic organiztion. Bodley’s text is an anatomy of how scale factors adversely structure political economy, an invaluable work.]

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  1. eCurrency Arbitrage

    Mortgage Brokers the capital requirement is high but it`s difficult to find a single countervailing positive for large capital concentrations

  2. Anonymous

    All debt and no savings means that there’s Hell to pay; call it Faustian capitalism”

    At the macroecnomic level, debt and savings are completely independent, non-comparable dimensions. Debt is financial. Savings is real. It is possible to have lots of debt and lots of savings. If you’re talking about distribution, you mean less debt in aggregate, but that doesn’t necessarily mean more savings. In fact, they’re non-comparable dimensions at the microeconomic level. The marginal real net savings effect of debt is 0 – negative savings for the borrower; positive savings for the lender. This includes households, business, government, and the financial sector.

  3. Richard Kline

    Yo Anon of 7:04: “The marginal real net savings effect of debt is 0 . . . .” No, that’s the theory of some, but in practice unpersuasive. But beyond that comment I’m going to neither argue or discuss that. Did you actually read the comment, friend? The point is that an economy that doesn’t save is headed for a deal of trouble. There have to be savings if lenders are going to lend, losses are going to be reserved, long-term expenditures are going to be funded gradually, and declining individual lifetime productivity is offset by personal assets. Do you have a relevant comment on that?

  4. Anonymous

    Not to lessen the obvious value of all the above, but the Nov 12, 2007 NYT cuts a bit closer to the bone…

    ‘…And as he awaits his official retirement next month, Mr. Prince can rest assured that he will leave with $68 million, including his salary and accumulated stockholdings; a $1.7 million pension; an office, car and driver for up to five years — all in addition to the bonus. That is on top of $53.1 million he has taken home in the last four years, a period when $64 billion in the company’s market value has evaporated.’

    What result does anyone expect from a compensation system that, when forced to choose between the continuity of the company and the enrichment of the executive, will opt for the latter?

    The main drawback would be that first (and maybe only) solving this fails to provide much fodder for the publish or perish crowd.

    These people were paid to indulge in activities that inevitably were to bring down their employers!


  5. Anonymous

    Richard Kine,

    I’ve read “the comment” as much as I can, and hope to spend more time on it when I can see more consistent linkage with the real world. Hence my comment, which was meant to be probative and extractive.

    I agree with you generally on the issue of an economy and its saving. But you’re confusing saving with “inside money”. Its absolutely not true that “there have to be savings if lenders are going to lend”. US mortgage equity withdrawals had nothing to do with economic saving. Yet lenders lent. Many corporations fund investment from their own savings in the form of retained earnings. This has nothing to do with lending. The net macroeconomic saving resulting from matched lending (bank assets) and what you erroneously refer to as savings (bank deposits in this case) is 0. An economy’s saving is not a direct function of financial intermediation.

    So I agree with your overarching point on saving. But if you consider the possibility that you might be confused on a fundamental monetary issue in your intepretation, friend, you and I might both be able to increase our understanding of your view of the world.

  6. CW

    Richard — Great work. It’s about time we started looking at our financial system from a truly systems-oriented perspective.

    Additionally, it seems that we need to get people to start asking even deeper questions about the foundation of our monetary system itself:

    What is money?
    Where does it come from?
    How does new money get into circulation?

    … once one answers those questions, the inherent instability of our monetary and thus financial system is apparent.

  7. CW

    Oh, and here’s an interesting post on current events, also from a systems perspective:

    Once we start looking at financial, environmental, energy, and agricultural policies holistically, things really start to get interesting.

  8. Richard Kline

    So CW, I would love for us to take a systems review of US agricultural policy, no question. We have a lot of agricultural resource to work with but rampant corporatization and its values of externalization are literally killing the goose. Feed lot stockraising is more costly then we truly reckon with. There is so much more there, but the government is far more likely to simply push subsidies at corporate actors if the fuel pinch destabilizes our production and distribution processes. it’s no pretty picture.

  9. Anonymous

    Finance isnt electrical engineering. Soon there will be little need for elaborate financial systems.

  10. Anonymous

    “Insufficient and imprudent capital reserves and excessive leverage … are directly contributory to every bubble you will ever research. High connectivity is associated with undampened propagation.”

    I think I agree with most of what Richard Kline wrote. But it’s a little heavy on the systems theory. Your typical thick-necked Wall Street jock (think Hank Paulson) needs real-world specifics hammered into his thick skull. Here are mine.

    First, go back fifty years, and most banks kept substantial reserves (often 10% or more). Since Greenspan effectively eliminated reserves in 1994 by allowing overnight sweeps of demand deposits into low-reserve savings, reserves at the Fed have stagnated in the $40 billion range — trivial in relation to bank assets. This is a gross, unnecessary centralization of risk.

    The moral hazard presented by FDIC insurance and brokered deposits is well known, and has just whacked us again with Indymac. Somehow, insured depositors need a reasonable incentive to care about bank solvency (e.g., a 95% loss payout rather than 100%)), rather than intentionally seeking out risky banks. I’m an example: I have deposits at derivative king JPM Chase, knowing that it’s the most recklessly-managed bank on the planet. But it’s also Too Big To Fail. That’s perverse.

    Finally, Kline’s comment that “large concentrations of capital concentrate risk” is one that I have harped on before. Under what authority has the Federal Reserve accumulated an off-balance sheet custody account that is 2.5 times the size of its own assets? This account essentially measures the scale of international check kiting between central banks, as they honor each other’s paper chits. Centralizing risk this way guarantees a train wreck somewhere down the line.

    The Federal Reserve has committed a disastrous reign of error which has left the financial system in tatters. Demanding MORE regulatory power — as it’s doing now — is a sad and classic example of the perverse incentives within government, where failing on an egregious scale brings more funding and more authority.

    Oh well, I’m off to stick some more pins into my Greenspan voodoo doll. Suck on this, Magoo, you superannuated charlatan!

  11. Nude

    It is time to consider the return of the forced loan. Above a set level of taxes, further premia should be assessed against income and gains where money is borrowed at nominal interest rates and repaid at or over a set term. Payees having the option to roll over their funds, perhaps with a tax incentive. This should start with high net worth, but eventually directed loans should be assessed against all earners in some amounts; whether to apply this to businesses is debatable. Developed in antiquity, the forced loan was a favorite of pre-banking societies; it’s principal use was to finance warfare, an admittedly bad precedent which should be specifically barred by statute. Furthermore, government falls in love with income sources, and revenue flows grow constituencies, so care needs to be given to the destination of such capital. Most certainly directed loans should be partitioned from general fund expenses.

    This was put into practice in by Congress and the President of the United States. It was called the Social Security Act of 1935. Government forced savings by employer and employee to be repaid at a later date, in this case, when the ‘lender’ reached an age of 65. Given the behavior of the government in it’s handling of both the money accumulated and it’s continued extending of the “retirement” age (or the restatement of the repayment terms, if you prefer), it would be a mistake to trust the government again. While it may sound like a great idea, in practice your stipulation that “by statute” they be restricted in both how and where this new revenue would be spent suffers from fatal optimism; what one Congress does, another Congress can change, undo, or ignore altogether in the name of political expediency and history shows this to be a statistical certainty.

    With all due respect Mr. Kline,
    I would suggest that you look for more examples of your theories already in practice and examine the results of their practical application. Your ‘solutions’ smack of socialism. At a time when our government is spending more than it collects, and owes more than $9.5 Trillion on top of that, we can’t possibly benefit from a plan that is essentially a rewrite of Roosevelt’s New Deal.

  12. Anonymous

    I have commented before, as a non-Economist about the primitive modeling and theory of Economics and so this column shocks me but does not surprise me.
    It was in 1934 that Bertalanffy presented a systems model and Kurt Lewin was even earlier. And the growth of General Systems theory started in the 1950’s.
    Economics claims to be a “hard” Science and is awarded a Nobel prize. But is seems divorced from interactions with advances in the Social Sciences.
    At the heart of the “free market” theory is a sort of Darwinian notion that monetary reward will ensure. While one might suppose that there would be a continual search for a theory which might give a real edge. A hunt far and wide. Instead I see thinking as constrained and Dead-ended as Creationism.
    It gives me pause and I must question the very vitality of the free market theory – as well as any faith in its efficiency.

  13. Anonymous


    Great post! It’s a tribute to Yves that her blog can attract thoughtful commentators like you.

    I read your comments a number of times in trying to gather together the big picture. Would you mind humoring me to see if I got it right?

    Our financial system is screwed up. One of the key reasons is a flaw in the basic assumption that the increased speed and effectiveness of communication in combination with the elimination of barriers of any type(legal and regulatory) always lead to a more highly effective and healthy financial system. Unfortunately, the side-effects of unhindered access across markets and nations have brought our financial system to the brink of catastrophe. Because of the high connectivity of all parts of the financial system throughout the world, the poison has been able to spread throughout the entire global system in a quick and efficient fashion. You go on to explain that maybe barriers are not such a bad thing, as they may have slowed the spread of toxicity of certain financial products across markets, if they had been properly put in place.

    You further state that to have been effective, these barriers should not be in the form of a hard drop-dead bright line rule or measurement dictated by and requiring the action of a specific oversight body. Rather, they should be more in the form of a subtle, gradual and mechanistic protection system that is constantly on alert for the appearance of and/or increasing volumes of transaction activity that can put the entire system at risk. You refer to this as a self-modulating system. The alternative, putting the control of these barriers in human hands is inherently a bad idea, since those who control the on/off switch could influenced or corrupted by personal bias, political or financial considerations.
    It seems you then go on to explain your belief that without self- modulating barriers(defense mechanism) that capital tends to aggregate in large concentrations, under the control of a few and then tends to cause associated concentrations of huge risk that will eventually lead to monopolistic tendencies or worse, the demise of the entire system if left unchecked.

    You suggest one solution as a “forced loan” where (I’m not sure at what level you suggest) people are required to save a certain part of their income (possibly receiving tax incentives in return) and the government has a permanent additional funding source from certain taxpayers.

    If I may, I’d relate the concept you describe to one, of which no doubt you have already considered, similar to an organic, dynamic, biological and evolutionary system- the human body. We know when our body is fighting a major viral or bacterial infection by the fever through which we suffer. However, most of the time the body’s defense mechanisms act in a more subtle fashion, with antibodies constantly on alert for invaders.

    Anyway, again, great post. I always look forward to your comments. I agree whole-heartedly with everything you wrote (not so sure about the solution though).I suggest that you consider the group of folks for whom you are most trying to influence. I would think that you’ve already impressed the elites many times over. My guess is you have a strong background in education. If you really want to elicit change, focus on the larger group. If they are like me, they have to read your comments two or three times before digesting the content. Maybe you could write in a more down to earth style. Alternatively, maybe I’m just too thick. Regardless of how you write, I’ll continue to look forward to your posts.

  14. Richard Kline

    To Nude, I suggest that you read the earlier pieces of this series to which Yves has provided links above. There are specific discussions of economic contexts there enough. Here, I move en brief and rely upon the reader to conceptualize or this would be pages long.

    With regard to Social Security, that is the obvious example of something that looks _like_ a forced loan, yes. I didn’t speak to it directly because it little fits the profile I would suggest by this concept, in part for reasons you yourself advance. The term of return is too long. It isn’t really a direct contract for sum but rather a general obligation. The revenue goes into a general fund that is neither bonded in bundles nor isolated from the larger budget. And that general fund is too subject to Congressional manipulation. A forced loan would look more like a bundled micro-bond in a capitalization of an infrastructure investment fund which could be spent only for that purpose. Or would go into a government guaranteed GSE issue, with the GSEs being fully public enterprises with somewhat difficult design: in that case we would ‘lend ourselves’ the money for mortgage subsidies.

    And you use the word ‘socialsim’ like it’s an epithet rather than a half measure. We need to get smarter and more thorough then socialism exactly because government bureaucrats can’t micromanage investment successfully, the process is too rigid and connectivity is too high. Socialism with dynamic constraints and government mediated syndicalism—that’s what a forced loan might look like in practice—are more in order. I will be perfectly happy for the system to suck the sur wealth out of the yacht you were planning to buy and into childhood nutrition and immunization, no problem. And so would 95% of the public. That other 5 %: they can emigrate. —Or better stay, because it will be a better country that gets built.

  15. Richard Kline

    To plschwartz, I really suggest that you go back and read the pieces in this series through, first to last. I don’t think you will retain a conclusion that I’m supportive or economics as a discipline as it is practiced, or that I endorse ‘free markets,’ or the like. And anyone who thinks that the other human disciplines constitute social sciences isn’t using judgment I would depend on for my observations, either.

    If one skimmed this particular post, it might be easy to form the conclusion that I endorse some kind of New General Dynamics: I do not. I have considerable respect for Lewin as a thinker, and Bertalanffy did the best he could with the tools and reasoning of his time. However, the stochastic and indeed chaotic qualities of complex systems were insufficiently understood at the time of the General Systems models. Moreover, most of the variables were too generic, and presupposed that what they measured constituted relatively stable components. Those assumptions are invalid.

    Relational modeling isn’t about ‘prediction,’ and this is an essential distinction. One can estimate general states of a system, but predicting exact states is a fool’s enterprise. Science as we know it is about prediction; that is the large part of what is wrong with it, and I don’t propose that we carry over that positivist predilection into further studies, no. Nor do I think it wise to attempt to model the financial system as a whole in any detailed way, the purpose of General Dynamics, for example. We are at the stage of looking to see how changes in particular variable vectors correspond to changes in particular sub-system state-spaces. That is the function of relational modeling, where real data from observable behavior can be tracked if not necessarily manipulated. This is the perspective I have pursued in discussing connectivity, for instance. Basic interactions in the financial system are poorly understood, and relational rather than predictive models can help with this, and ideally yield us somewhat better regulatory and investment tools.

    I have no special love of free markets, but mass behaviors cannot be centrally controlled so we are going to have markets; the goal is to have functional markets, and to know what dysfunctional behavior _is_. We are at the stage of understanding markets that observers in the 1750s were at understanding psychological behavior, that is 150 years short of even a basic theory though committed to empirical observation at least. Let’s get better at this, is what I’m saying.

  16. Richard Kline

    To Anon of 4:52, you follow my arguments well on the whole, so I guess that is confirmation that there _is_ an argument here somewhere and I’m not just dribbling spit. : )

    Let me clear up a few things further. Large concentrations of capital are probable and problematic, but they are not the only problem. Even systems composed entirely of small nodes can crash if they all correlate their behavior: we can’t all buy low and sell high. And single economies entirely walled off from regional and global economies are some of those _most at risk_. Consider Zimbabwe, this is a closed system, yes, and a failed one. Large trans-national capital markets do actually promote democracy because they put a brake on graft and shield _themselves_ from money-printing inflation. They’ve done a poor job of shielding themselves from credit balloon inflation, though. All the talk we’ve heard of the financial markets’ ‘policing reckless government policies’ isn’t simply self-love, there is a reality level to it, but if they are raking in fees they go blind and deaf. Frailty, thy name is Mammon.

    The question to me isn’t whether to have markets, but more how to internally and externally regulate their behavior so that greedheads and our own ignorance don’t keep crashing them. Which is otherwise what has happened _even and especially before the recent round of ‘financial innovation’_ (sic). Regulation, both public and by counterparty contract, has been severely pro-cyclical and pro-concentrative (if that’s a word). Markets overshoot; that has been known for four generations; this is much of why, though other issues such as connectivity come into play as well.

    Financial innovation was a liberal project not a conservative one, and it has the typical liberal perspectives. There was and is an underlying assumption that it is tired social rigidities and our own ignorance and irrationality (fear, greed, exuberance) that ‘crashes the system.’ We should remove barriers. Let experts make the decisions (like them). Hew to the numbers to stay clear of emotions. . . . And here we are. Again. There is an underlying liberal economic expectation, for example, that the business cycle is induced by our dysfunctional behaviors, and that heroic economic scientists can smooth it out so that an unending and unblemished trajectory of growth which the economy ‘would really display’ is allowed unconstrained progress. That belief is cant and delusion, I may say. Cyclicality is not induced but inherent, and unconstrained growth is a cancer. One can see presently how we got to record financial disaster in record time cooperating with liberal delusions. What we need are better observations, and ones not predicated on making ourselves personally rich if we are ‘right’ in the near term. I’m not in the least advocating conservatism, but I cannot stress enough that liberal philosophy is stuck in early 19th century economics and wildly dysfunctional. Radicals had a better critique, but haven’t had their turn at generating better solutions, in part because they have had too few of them, and those often wrong as well. (Conservatives don’t have solutions, they have positions, which they mean to retain and the Devil take the rest. Libertarians . . . don’t have enough medication; cannabis works, I’m told.)

    Anon, you use the metaphor of the human body for passive threshold constraints. In some ways this is a good one, but I have resisted using it explicitly. ‘Organic metaphors’ in the human disciplines have a very unfortunate (liberal) history, to the degree that I stay away from them even where appropriate. We need mechanisms like self-sealing tires, for example. I do give credit to financial markets for generating some such constraints, like the margin call. Rating bonds was not a bad idea, but letting it function by a profit motive was. Consider the difference in evaluation one gets from Consumer Reports and captive tests by product manufacturers; uh-huh. I’m not saying that we should do away with human regulators, either; one has to have someone to watch a boiler even if the boiler has a governor: shit happens, know what I mean? But interventions should be automatic, node specific, and gradual, with human custodians largely reporting on progress and only intervening directly under extraordinary circumstances. Get the best of both man and process, as it were.

  17. Nude

    And you use the word ‘socialsim’ like it’s an epithet rather than a half measure. We need to get smarter and more thorough then socialism exactly because government bureaucrats can’t micromanage investment successfully, the process is too rigid and connectivity is too high. Socialism with dynamic constraints and government mediated syndicalism—that’s what a forced loan might look like in practice—are more in order. I will be perfectly happy for the system to suck the sur wealth out of the yacht you were planning to buy and into childhood nutrition and immunization, no problem. And so would 95% of the public. That other 5 %: they can emigrate. —Or better stay, because it will be a better country that gets built.

    If your desire is to build a better country, then I invite you to find some empty land and create your own utopia. This will provide you the freedom to enact any hare-brained scheme you can think up. It certainly would be easier than your approach, in which you seem to value our economy only for the wealth that can be redistibuted without regard for the manner in which wealth is created or the dynamics which allowed this country to climb to the top of the economic ladder in the first place. There is no “sur” wealth, there is simply money that is not being spent in the way that you would prefer but, since it isn’t yours, you call on government to confiscate it for “public” use in a manner that is more to your liking. 95% of the public doesn’t want government to arbitrarily decide that they can have “this much money and no more”. They want the ability to be able to pay for these things (healthcare, child nutrition, housing) themselves, to choose how and where the pay for it, and how much they will pay. What you outline takes away those choices, and the opportunity to ever make them, by replacing them with your “better country” when all they really want is the ability to create their own wealth.

    If socialism isn’t an apt description, would communism be a better fit or shall we go old school and just call it Marxism? At any rate, I’ve read your stuff. I was reminded of a process used by salesmen to distract customers from potentially deal-breaking details and flummox them into forgetting about it; it’s called “baffle them with bullshit”. You over complicate simple subjects, over simplify gaps in reasoning, and get verbose when trying to sell a point. It happens to the best of people, but it isn’t an attribute I wish to encourage. Furthermore, don’t attempt to play the class-envy card with me again, our family makes less than $100k a year and my truck was built in 1985. You can try and use emotions (think of the children!) to sell your arguments but that doesn’t do anything to change my opinion of your proposals while saying much about your ideology.

  18. Yves Smith


    We already have socialism in this country, and it doesn’t serve the average Joe very well on the whole. I suggest you read Dean Baker’s The Conservative Nanny State. That’s good one-stop shopping on this topic.

    I find it ironic that you defend our present system, which among other things socializes risks of the banking system and privatizes its gains. In a post we ran yesterday, Willem Buiter decried the US system of socialism because it is covert and dishonest. You may not like proposals like Richard’s but they force the discussion of what we are paying for and why into the open.

    Australia is more socialized that the US, and the population is far happier with the outcomes it produces that our population is with ours. Their population as a whole is more left-leaning than ours (people there who think government is bad are regarded as extremist cranks). It has had better growth than the US from 2000 onward and also has had strong appreciation of its currency since 2003.

    That is a long winded way of saying strong safety nets and more stringent regulation are not incompatible with economic growth.

  19. Anonymous


    Thanks for the response and further clarification. I think I get it. You’re not proposing closing down connections between markets- just somehow tweaking the exchange points (appropriate regulatory systems) to provide additional safety and security to keep problems from spreading too expediently between markets.

    Also, I think I get your proposition that markets will experience cycles naturally. While people in positions of power can make things worse, market downturns will periodically happen regardless of what these folks do. Trying to permanently protect markets from a downturn will cause a result that is similar to what happens when a dam is erected to permanently hold back the flow a raging river(without periodically providing emergency controlled overflow releases). Just not possible.

    BTW, while I enjoy your posts tremendously, they’re written at such a high level, that when I step away from the computer, I’m the one who’s got the feeling that he’s dribbling spit. Thanks again for sharing your thoughts.

  20. Nude


    I agree that regulation isn’t always a bad thing. I am not defending our current system, but I am not advocating a more socialistic one either. We’ve gone 70 years without a major crisis like we are currently witnessing and while lack of regulation and oversight may be the cause, it doesn’t indict the entire system or show cause for it’s complete overhaul, as proposed by Mr. Klein.

    Not to be contentious, but I am dubious of any uncited references where people of one country are compared to another in completely subjective self-evaluations. Australia may be completely happy with their system, but we don’t know if they would be happier under ours unless they are forced to live under it en masse and for a long enough time for it to become normal.

    BTW, love your blog.

  21. Dave Raithel

    Let’s call a modern, post-democratic (or decadent democratic) system that “socializes risks … and privatizes … gains” fascist, and leave the socialists their space in the polity. What I know about systems theory I pulled from David Berlinksi’s little book of 30 years ago, “On Systems Theory”, and so like many of the other commentators, I often find Mr. Kline’s analysis more obscuring than illuminating – I need more of the mapping from the systems model nodes to the concrete actors being represented in the model. But it is since I dwell more in the particulars through time, I don’t take much consolation from Nude’s claim that “We’ve gone 70 years without a major crisis like we are currently witnessing and while lack of regulation and oversight may be the cause, it doesn’t indict the entire system….” The entire system is what’s been stumbling to a collapse since Johnson and Company failed to pay for warring in Vietnam –

  22. Richard Kline

    To Anon of 8:37, maybe more than tweak markets. However, they do have their uses, and regardless we are going to continue to have them, so it’s essential we understand their systemic weaknesses and seek to mitigate those rather than exacerbate them. That has been my goal of asking questions in this series, now over.

    Regarding US financial crisis ‘since Johnson,’ we are now on Number Six, and the US policy response every time has been the same: balloon more credit into the system, and leverage our overvalued currency to continue to support demand. If we had had a mid-duration cyclical downturn turing the 90s it wouldn’t have been pleasant, but it would have been less severe than what we can likely expect now, and might well have prepared the way for both financial reforms and a more stable innovation logistic expansion. Our attempts to eliminate cyclicality have amplified the overshoot; that’s a bad trade off.

    And those putative 70 years without a major crisis; please. Our position in the period 1945-65 was unique, and moreover on the upslope of a long-term cyclical movement. But wait, there’s more: many of the major financial crises _elsewhere_ in the world are a direct result of US financial processes. Mexico and most of Latin America from 82; Mexico again in the 90s; Japan on a colossal stock and real estate bubble after the hugely distortive Plaza Accords which overvalued the dollar; SE Asia and Korea in the 90s bloated on Anglo-American capital; Argentina again. Yes, those countries and their peoples are implicated in their own crashes, and some of them would have bubbled without our help—but we more than helped, we pushed in every case. I’m not going to detail this; the facts are readily available to anyone who cares to look at the economic history of these situations. In fact, it is not to strong a statement that the US exported its financial weaknesses and losses through our currency to areas too weak to take the strain. Lest you think that I blame the US for every bloom that wilts, the Turkish financial crisis, the Russian one in the late 90s, and to a large extent the property bubble in the EU of the last stretch have not been principally driven by macrofinancial vectors out of the US, in my view. Most of China’s financial gyrations before the last two years are internal processes as well. However, the idea that ‘our system works’ doesn’t look nearly so sweet, just, fair, and stable when you really look at who funded who and how and what of it.

    And that is one of my problems with your perspective, Nude. It is manifest that you don’t see the systemicity of capital. You live in a sweet spot, and the big picture isn’t for you. I would be more impressed by your dissent if I had any reason to believe that you followed anything in the discussion on systemic instability. Instead, it’s clear from what you do and don’t take issue with and how that you are baffled and see that as my fault, nay the result of some perverse rhetoric and ideological skullduggery on my part. Lah.

    Further, you are mistaken that the goal of these pieces is a rhetorical one, to sell an ideology. You are the one hanging labels on me; if you followed my comments over time here your inaccuracy in casting isms at me would be more evident to you. But here’s a question: Do I take issue with individuals in my society looking to enhance their own wealth? If that destabilizes the whole system, yes. If that is at the expense of the system and society as a whole, yes. If not, then not. I have no problem with billionaires or paupers. I do have a problem with billionaires buying a political party to get themselves granted a tax holiday _manifestly_ at the expense of the rest of their society. I have a big problem with financial speculators who cost others everything. I have a problem with fools speculating on their house values to enhance their personal wealth and so swallowing the Get Rich lie, driving housing prices out of reach, then crashing them leaving millions on the hook for market top debt. But really none of these issues is at the heart of anything in this series of posts. The very last comment in the very last post I’ve made seems to have stuck in your craw; well spit it out, friend. I invite you to go back and read the posts in this series again and see if you care to comment about systemicity in a substantive way. Others have found non-ideological points of structural relevance there, and so can you should you so choose. And BTW while I prefer Klein my family spells it Kline.

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