Sunday, March 19, 2023

Greater Liquidity Produces Instability

Lowering of boundaries between markets ranging from the large number of global macro hedge funds to the large number of retail currency speculators is destabilizing. I’ve found occasional supporting bits of empirical evidence on financial crises, which found that greater financial integration was correlated with crises - however - there is currently no mainstream theory which articulates this hypothesis.  Conventional economic wisdom would tell you arbitrage is always and ever good (it supposedly improves price formation which leads to better allocation of capital), and inefficiencies are bad. 

However, complex systems theory provides a very different perspective:

Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn’t make risk go away, but moves it more quickly from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.

This principle has been recognized in the design of software systems for several decades now, and is also a design principle recognizable in many other systems both natural and artificial (e.g., biology, architecture) which are very robust with regard to exogenous shocks. Stable systems tend to be built from structural heirarchies which do not share much information across structural boundaries, either laterally or vertically. That is why you don’t die from a heart attack when you stub your toe, your house doesn’t collapse when you break a window, and if your computer crashes it doesn’t take down the entire Internet with it.

Glass-Steagall is a good example of this idea put into practice. If you use regulatory firewalls to define distinct investment sectors and impose significant transaction costs at their boundary that will help to reduce the speed and amplitude of signals which will propagate from one sector to another, so a collapse in one of them will be less likely to cause severe problems in the others.

THEY have torn down most of these barriers in the last few decades in the name of arbitrage, forgetting that the price we paid for them in inefficiency was a form of insurance against the risk of systemic collapse. This is exactly what I would do if I wanted to take a more or less stable, semi-complex system and drive it in the direction of greater non-linearity.

Is it a symptom of the decay and loss of trans-generational memories from our last great systemic shock in the 1930s?  Or is it the result of something more structured and intentional? I suspect that something like this is bound to happen every 3-4 generations as we unlearn the lessons our grandparents and great-grandparents learned to their cost.

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