To understand finance, embrace complexity

Ahighly unusual collaboration between economists and scientists offers an important insight for those who want to fix the world's crisisprone financial system: There's no simple way to understand a complex network.

This month's issue of the research journal Nature Physics features a handful of papers in which physicists, other natural scientists and leading experts in economics and finance -- including prominent banking regulators and Nobel Prize-winning economist Joseph Stiglitz -- put their minds together to figure out finance. What the scientists bring to the table is experience in studying networks, bewildering tangles of interlinked and interdependent things such as an ecological food web or the Internet.

Take a look at any diagram showing the interconnections among the world's banks and other financial institutions -- links established through ordinary loans, but far more extensively through financial derivatives -- and what you see will be very complex. We barely understand how such complexity changes the way networks operate. What we do know suggests we should worry when there's too much of it.

Fifty years ago, ecologists interested in the stability of food webs at first mistakenly concluded that more complexity -- more species and a greater density of links among them -- would tend to make an ecosystem more stable. This turned out to be wrong. Later work by noted ecologist Robert May demonstrated that while healthy ecological networks are rich and diverse, too much complexity tends to make them unstable and prone to collapse. Loosely speaking, networks with too much complexity can go wrong in too many ways.

Sound familiar? The complexity of the financial system exploded over the past few decades, primarily through the proliferation of derivatives of all kinds. Then the system itself blew up. What the papers in Nature Physics argue is that any really deep understanding must focus on the detailed pattern of links among institutions, or the network "topology." (Full disclo- sure: I write a monthly column for Nature Physics.)

I've touched on networks several times in earlier Bloomberg View columns. It's worth emphasizing again how the most basic insights emerging from this new line of work run contrary to received wisdom from economics. For example, banks that create and sell derivatives often argue that their proliferation is beneficial, as it makes markets more "complete," meaning that it brings us closer to a world in which essentially any kind of trade or bet can be undertaken at any time. Standard financial theory assumes that such completeness is associated with greater financial stability, as it allows anyone with information to bring it into the marketplace. How can that be bad?

Well, achieving completeness entails a vast increase in complexity, with consequences that traditional finance models fail to capture. These models suppose that the actions of individuals or firms in the market are too small to affect its behavior in any serious way, much as we used to think that our fishing the oceans would have minimal influence on the abundance of fish. But a network study from several years ago demonstrated that the seemingly tiny influence that trading has on the market becomes increasingly significant as the number and complexity of financial instruments increases. The generic result is violent market fluctuations and instability. Financial institutions still find ways to profit by creating and selling new derivatives, even if these deliver no benefits to the market and actually drive the system toward trouble. blog for further details.)

Complexity also helps financial institutions hide the risks they create. Despite the advertising of the International Swaps and Derivatives Association and others who create and sell derivatives, these products are only sometimes used for hedging and much more frequently for speculation. In the latter case, they are exceedingly useful in obscuring information that would be crucial to the proper judgment of values and risks. Consider the derivatives that helped Italy's Banca Monte dei Paschi di Siena SpA hide hundreds of millions of dollars in losses as it sought a taxpayer bailout. Anyone making deals with a bank enmeshed in a largely invisible web of contracts with far-flung counter-

(See my parties does so with a very incomplete view of the risks involved.

The basic complexity of the market allows for the completion of deals that would never get signed in a world of full transparency and understanding. Unfortunately, traditional financial theory -- which assumes that individual actors have perfect knowledge and make only rational decisions -- ignores this point, blinding itself to a huge source of systemic risk. Any science has to begin with basic insights first, learning which details really matter and which may not.