Thursday, May 21, 2009

Making the Economy Robust To Black Swans

Cygnus atratusImage via Wikipedia

In a recent twitter conversation about managing chaotic systems by pushing the system to linear instead of non-linear responses to shocks.

Which does lead to the question can you have linear response to shocks in a non-linear system? Short answer is yes. Even in non-linear system there is a portion of response that is linear, with the response becoming non-linear with further driving.

In effect you structure the system (with dampeners etc) based on the potential response of the system to the shock. This method doesn’t plan based on a probability of an event occurring rather based on what would happen to the system should the shock occur. The aim isn’t to prevent shocks rather control how the system (in this case the economy) reacts to shocks.

Economic systems respond to shocks in 2 ways by destroying demand and freezing of money (or credit). Unfortunately, the responses are coupled and one will cause the other which in turns feeds back in. The key is to keep either from precipitating the other.

The money freeze occurs as the system tries to workout where the risk is. An event has occurred (such as a failing institution) that has demonstrated that the risk in the system is not understood. Money stops flowing as everyone aims to identify where and who has the risk.

To dampen this response:
  • Ensure all financial transactions are transparent. This involves using marketplaces and exchanges and avoiding all trading in financial instruments over the counter.
  • Reduce the amount of risk that is in question by structuring the economy so financial institutions can never large.
The demand destruction is as it’s name suggest the removal of demand from the system. An event has occurred such as the explosion in price of a key input over a very short time (such as the oil shock of the 1970s) that creates a situation of mass layoffs reducing the demand within the economy.
To dampen this response:
  • Provide a system that allows private demand to be replaced quickly by public demand (i.e. infrastructure building)
  • Reduce the loss of demand by income smoothing that avoids people suddenly reducing spending drastically as they are laid off
It is reasonable to point out these dampeners are already in place. Yes to extent they are but it is ad hoc and not very effective as currently done. Take for example the demand replacement. Many countries have proposed infrastructure programs. However, these don’t get underway (the building aspect) for a period of years. The demand needs to be replaced immediately not in 2 years time when private demand will be increasing. Instead, projects that create public demand need to be maintained at a point that allows them to be instigated within 3 months.

While unemployment benefits go towards smoothing income, it still results in a massive reduction in demand as unemployment benefits a pegged at subsistence level. To smooth income properly, a program of income-contingent loans for redundancies and training are needed that avoid the drastic reduction in for a period of 6 to 18 months.

Focusing on system response to shocks instead of trying to model the probability of shocks moves us away from the realm of make-believe that is probability forecasting to focusing on making the economy more robust and able to handle Nassim Taleb's Black Swan events.

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