[TL;DR – This all should have been obvious because complex adaptive systems like the economy always break down, just like in 2008. It was not obvious because we understand the economy through a flawed framework.]
Hi folks,
About a year ago I wrote this piece called The Coming Crisis which got a big response (both positive and negative) here in r/stocks. I was encouraged by user /u/cristhm to make a follow-up, so here goes. It’s late right now so I’ll try to make this relatively concise while still hitting all the major points.
In short, most of what I said then and what I’m saying now can be summed up by economist William White in this video:
Look up “William White – Conducting monetary policy in a complex adaptive system”. I can’t post YouTube links here.
Don’t worry, the talk itself is only about an hour and well worth it. I found the questions at the end to be interesting, too, but the important part is only the first hour.
Summary of Mr. White’s talk:
The economy is not linear (the traditional model used by economists), but rather a complex adaptive system. Think of it like a garden. You plant the seeds, and you can water it and stuff, but you never really know what’s going to happen. There can be a flood. A snake can get in. There can be an invasive species. Weeds pop up here, flowers die there, etc. The system is too complex for you to entirely understand, because there’s too many variables, and not only that, but each one of those variables interacts with the others and has the ability to adapt given changing conditions. Forgive me if I didn’t explain it 100%, I haven’t read any work on complex adaptive systems myself and simply try to paraphrase Mr. White.
An example I love to use is the book / film Jurassic Park. The idea was that the owners had the whole park under control, what with security fences and cameras and the dinosaurs not being able to breed or survive without a special food from the handlers for more than 3 days. But the system was complex and adaptive, so somehow the dinosaurs found a way to escape and to procreate and survive on their own. If you think about it, it makes total sense. Obviously bringing back extinct dinosaurs from the dead and making a theme park was a horrible idea. But it really goes to illustrate the folly of trying to “play God”.
Jurassic Park is a great illustration of how complex adaptive systems are unstable and tend to break down. Another example of breakdown in these systems would be the ecosystem which included the dinosaurs (Michael Crichton wrote about this in the sequel, The Lost World).
How does this relate to markets / the economy? It’s because, as I said, financial markets and the economy are complex adaptive systems, and the issue is that we haven’t been treating them as such. For decades people at the Fed and central banks have assumed that as long as prices are stable then we need not worry about macro stability. William White argues that this is a grave mistake. There are other issues, including asset price bubbles and rising debt stocks. In fact, this was the entire cause of 2008. William White wrote about this in 2006, 2 years before the crisis hit in full force:
Is price stability enough?
Here’s a quote from that paper:
“Following on these arguments, an altered framework for conducting monetary policy would demonstrate more symmetry over the credit cycle. There would be greater resistance to upswings. This, in turn, would obviate the need for asymmetric easing in the subsequent downturn and the problems arising from holding policy rates at very low levels for sustained periods. One important effect of more symmetric policies is that they would also act to prevent financial imbalances from cumulating over time. This, in turn, would free the authorities’ hands to respond appropriately to the upward phase of any given credit cycle, since there would be less fear of precipitating a crisis. In this way, a virtuous rather than a vicious circle might be more firmly established.”
He ends with a statement that was eerily prophetic for the year 2006:
“One hopes that it will not require a disorderly unwinding of current excesses to prove convincingly that we have indeed been on a dangerous path.”
It’s a statement that, in my view, applies just as much today as it did in 2006.
He also wrote something that applies very much to the situation we are facing now:
“On the other hand, the Japanese reliance on “quantitative easing”, in addition to very low interest rates, highlights a further complication as monetary authorities begin to tighten. Economic agents more generally will be aware of the extent to which banks have reserves well in excess of normal requirements, and could become increasingly concerned about their inflationary potential. This implies a delicate balancing act for the monetary authorities, in which tightening must be slow enough to avoid destabilising financial markets, but fast enough not to destabilise inflationary expectations.”
For more issues with QE and monetary policy, check out his 2012 paper:
Ultra Easy Monetary Policy and the Law of Unintended Consequences
So what’s the solution?
The truth is that we have backed ourselves into a corner. We are between a rock and a hard place. The solution, it seems, was to have never gotten here in the first place. But now that we’re here, I would argue, as would Mr. White, that we ought to have a serious conversation about what we’ve been doing for the last 20-30 years. Given that complex adaptive systems are prone to breakdown, we ought to do our best to be prepared for that breakdown. But that’s not what we’ve done. Instead of deleveraging after 2008, we’ve actually become more leveraged. Government and corporate debt are through the roof. Vulnerabilities have not decreased, they have increased, and greatly so.
How has our economic system broken down in the last 2 years?
-Coronavirus
-Enormous and unprecedented liquidity (on top of already enormous and unprecedented liquidity post-2008)
-Inflation that proved to be persistent rather than transitory (another failure of the Fed and central banks to forecast complexity)
-Russian invasion of Ukraine
-Issues in bond and currency markets (pound, yen, euro, Bank of England buying gilts)
It seems that the Fed and central banks were always making their forecasts under the assumption that everything was simple and going to go according to plan. But we have seen, obviously, that this has not been the case. But this should have been expected! This is the nature of complex adaptive systems, and to be a bit philosophical, it’s the nature of life itself: uncertainty. The fact that the Fed missed it in their forecasts is because their framework is flawed. It’s the same reason they missed 2008.
Where are the vulnerabilities now?
Me personally I’ve been worried about a strong dollar and what that means for sovereigns and businesses who have to pay their debt obligations in dollars. Mr. White mentions this as a potential issue in his video (remember, from back in 2018). We saw some real weakness in the UK today. Here’s a good article I found. It’s a tabloid but it does a nice job of summing up what happened:
https://www.thesun.co.uk/money/19943278/bank-england-drastic-step-stabilise-economy/
I don’t think this is necessarily the tipping point, but it’s a serious sign of instability. There is likely much more that we don’t know about yet.
What’s going to happen?
I don’t know. Is there a possibility that we make it out OK? Yes, absolutely! But it’s also true that we’ve gradually built up a lot of vulnerabilities in the system, and the longer we keep going down this path, the more precarious the situation becomes. Herbert Stein said that “if something cannot go on forever, it will stop”. A colleague quipped back: “but it will go on much longer than you expected!”
So I can’t tell you when the whole system is going to come undone, but what I can tell you is that we’re on a very dangerous path. It can’t go on forever. And I am very worried about the way things are looking right now.
What should we do as investors?
I’m not an expert investor, I’m a new investor who studied economics and continues to study it in his free time as a hobby. That said, I don’t think anyone should panic sell. If you’re going to sell, please do so after doing your own research, not after reading this silly Reddit post. What I can recommend to everyone, and I think it’s fair advice, is to be prudent. Be honest about what’s going on right now and do your best to try to understand it. From there, make smart financial decisions that will be beneficial for you and your family regardless of what happens.
My addition to Mr. White’s work
Honestly, I think everything you need to know is all there. I have little to add. The only thing I would like to say is I agree with him on humility. I had a rough time growing up and that led me into addiction and alcoholism. It was humility, and recognizing that I had a lot less power than I thought I had, that finally got me out. I’ll have been sober for 9 years this Saturday. Humility was tough for me, but at the end of the day I found it to be more fulfilling (and more honest) than the alternative. I think as humans we all struggle with this, and that’s probably the reason why it’s so hard for us to accept complexity. It’s scary to admit that we don’t know.
Where I got it right from my last post
Well, things certainly look to be cracking. Markets are way down. Vulnerabilities are emerging.
Where I got it wrong
My thesis wasn’t fully developed, and I think I put too much emphasis on “I don’t know what’s going to happen”. That remains true, humility is a huge part of this, but I think more emphasis should have been placed on the topic of complex adaptive systems. When you view the economy in that light, the underlying vulnerabilities start to make a lot more sense.
Secondly, I obviously don’t know how all this is going to play out going forward. Today could have been the start of the next leg up. I don’t know. The crisis hasn’t fully materialized yet, but I still feel quite confident that we have been on a dangerous path.
Finally, my actionable investment advice came off as green and I should have stuck to generalities rather than specifics.
How this relates to r/stocks
This is not necessarily direct investment advice, but I do think it’s relevant to this community. Understanding macro is very important in order to be a good investor. I heard Mohamed El-Erian say today that “you can’t have a great house in a bad neighborhood”. So no matter how great you are at investing, macro will affect you.
Good luck to all and thanks for giving me a platform to share.
