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Understanding the financial crisis

The global financial crisis was caused by the collision of different systems, operating at different timescales. There are more shocks to come.

I’ve not been able to blog recently – a mix of work commitments and being away – but I’m delighted to say that during that time the article I wrote with Hardin Tibbs on the global financial crisis has been published in the Journal of Futures Studies. We argue that to understand the financial crisis, it’s necessary to look across multiple timescales, and at the same time. There’s a short-run story about the financial sector, going back thirty-forty years, which is also bound up with a technology story; there’s a longer-run story about energy, which goes back to the development of oil as a significant energy source in the early 1900s; and there’s another – more long-term – story about the end of modernity, a story which started being told around 350 years ago. Each of these suggest a system running up against its limits, and each of them on their own could have caused the crisis. The global scale of the crisis was because these different systemic stories started to interact. And looking at it in this way, it is clear that the crisis isn’t over yet.

The article can be downloaded here (opens in pdf) and I’ll leave it for the curious to work through the discussion about each element for themselves. The problem with S-curves, of course, is that they tell a story about what happens as an issue develops, but they have nothing to say about the transition from an sated curve (at the top of the ‘S’) and its transition to a new system. Since the crisis is a story of sated systems, this issue is critical.

Using the Panarchy model to understand social change

To understand this we drew on the ‘Panarchy’ model, which I’ve mentioned before in these pages. It was developed to understand change in ecological systems, and describes a figure-of-eight cycle in which a system exhibits different levels of connectedness and of potential over time. There’s some controversy in this, since not everyone thinks that the panarchy model is fit for use with social systems, which are more reflexive than ecologies. It’s possible that some of the ecological language is getting in the way; we found it a good model of systemic evolution. In effect it proposes a theory which links the sated end of one phase with the underdeveloped start of the next one. There are different levels of system resilience at different places in the cycle. It allows for the fact that systems don’t always succeed in this transition. It imagines that there might be nested cycles, in which different systems, moving at different speeds, are connected (and can conflict). And it allows for the fact that not all systems regenerate themselves after collapse.

Summarising the diagram, which passes through four phases. In the ‘exploitation’ phase (r) – exploitation is meant in a descriptive and non-pejorative ecological sense – there is expansion, in which a new system finds a niche and is able to develop, by building connections and potential. This is a period of system and capacity building, which creates the platform for rapid expansion. The emphasis in the ‘conservation’ stage (Κ) is on accumulation and storage of energy and materials. In terms of social and technical systems, this is a period of scaling up, of mature products. But the system also reaches climax, and its extensive connections lead to system rigidity and create vulnerability to external change.

The ‘release’ phase, or omega (Ω), which follows, is a period of rapid decline in the face of changing conditions or new competition. In terms of social systems, leadership is important. Finally, in the alpha (α), or ‘reorganisation’, stage, potential is high but connection weak. The emphasis is on developing sufficient variety to allow the system to redesign itself to have a chance of survival. Not all systems succeed in this.

Applying Panarchy to the financial sector

Applying this to the global financial crisis, as we write in the article:

Reading the financial curve in terms of the panarchy cycle, for example, the changes brewing in the banking system during the 1970s were similar to the ‘reorganisation’ phase. The period immediately following the ‘Big Bang’ in the UK, and other 1980s deregulation, was akin to the ‘exploitation’ phase, in which the industry built new capacity and new relationships to exploit the new opportunity. This was followed by the ‘conservation’ phase, as markets developed and the size and prestige of institutions steadily grew. This is a longer, slower, phase. The sub-prime crisis was the sudden ‘release’ phase, and a sign – borrowing the ecological metaphor – that the financial system had grown too large and complex to be sustainable, and was starting to destroy itself.

Because social systems are purposive organisations, whose members can act with intent, systems usually adapt in the face of such challenges, but only inasmuch as they can do this without destroying the benefits the system provides to its members. Parts of the system become over-optimised; parts are entrenched; parts are extended. For this reason, the collapse of complex social systems usually takes place over quite a long period of time, as a result of repeated shocks, not just one. In the face of collapse, there is also rhetorical dispute about the health of the system between different actors. From the JFS article again:

There is variation both between different systems, and within systems, which leads to interpretative conflict – itself a sign that the ‘conservation’ phase is ending. An ecological system which collapsed as comprehensively as the banking system did in 2007-08 would have moved decisively into the ‘release’ phase. Yet in late 2009, some actors evidently still believe that the purpose of public intervention has been to haul their businesses (and them) back to the opulence of the ‘conservation’ phase. Regulators, though, taking different perspectives, including the slower perspective of governance, are increasingly talking as if ‘reorganisation’ is inevitable.

(The article by Alessandri and Haldane which I’ve mentioned here before, and several of Adair Turner’s speeches, are signs of this dissonance.)

The crisis isn’t over – it may take years

The JFS article concludes that the crisis isn’t over yet, no matter what bankers and policy makers might think. We are likely to move into new areas of turbulence. There are three observations in particular:

  • in several important systems we will – soon – move away from the familiar area of ‘conservation’, in the panarchy framework, in which institutional behaviour, assumptions, and worldviews are well-rehearsed, well-known, and well-internalised. We will move into the unstable (and more rapid) phases of ‘release’ and ‘reorganisation,’ in which it is more important to watch for emerging issues and for new social practices, and to create space for innovation (social as well as commercial) by encouraging new connections
  • There is a cost in listening too closely to familiar (and influential) interests, whether in the financial or energy sectors. Their motives are to preserve the status quo, which they associate with wealth production, but which produce benefits for them but cost and risk for others.
  • Because we are in a dangerous place somewhere between ‘conservation’ and ‘release’ on several of the panarchy cycles, we are likely to see further shocks. We are in a world of incomplete ‘sense-making’, in which different parts of the system, and different systems, offer competing narratives. But policy makers are not good at living in
    transitional moments; they prefer apparent certainty to actual uncertainty.

Finally, as this starts to change, we’ll see more radical forms of intervention, intended to change the underlying systemic behaviour of the financial system rather than to curb it. But this won’t happen quickly; it could take a decade or more.

The photograph at the top of this post, ‘Global financial crisis’, is from Guendal’s photostream on Flickr, and is used with thanks.

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