Financial Entanglement and Complexity Theory. An Adumbration on Financial Crisis.

The complex system approach in finance could be described through the concept of entanglement. The concept of entanglement bears the same features as a definition of a complex system given by a group of physicists working in a field of finance (Stanley et al,). As they defined it – in a complex system all depends upon everything. Just as in the complex system the notion of entanglement is a statement acknowledging interdependence of all the counterparties in financial markets including financial and non-financial corporations, the government and the central bank. How to identify entanglement empirically? Stanley H.E. et al formulated the process of scientific study in finance as a search for patterns. Such a search, going on under the auspices of “econophysics”, could exemplify a thorough analysis of a complex and unstructured assemblage of actual data being finalized in the discovery and experimental validation of an appropriate pattern. On the other side of a spectrum, some patterns underlying the actual processes might be discovered due to synthesizing a vast amount of historical and anecdotal information by applying appropriate reasoning and logical deliberations. The Austrian School of Economic Thought which, in its extreme form, rejects application of any formalized systems, or modeling of any kind, could be viewed as an example. A logical question follows out this comparison: Does there exist any intermediate way of searching for regular patters in finance and economics?

Importantly, patterns could be discovered by developing rather simple models of money and debt interrelationships. Debt cycles were studied extensively by many schools of economic thought (Shiller, Robert J._ Akerlof, George A – Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism). The modern financial system worked by spreading risk, promoting economic efficiency and providing cheap capital. It had been formed during the years as bull markets in shares and bonds originated in the early 1990s. These markets were propelled by abundance of money, falling interest rates and new information technology. Financial markets, by combining debt and derivatives, could originate and distribute huge quantities of risky structurized products and sell them to different investors. Meanwhile, financial sector debt, only a tenth of the size of non-financial-sector debt in 1980, became half as big by the beginning of the credit crunch in 2007. As liquidity grew, banks could buy more assets, borrow more against them, and enjoy their value rose. By 2007 financial services were making 40% of America’s corporate profits while employing only 5% of its private sector workers. Thanks to cheap money, banks could have taken on more debt and, by designing complex structurized products, they were able to make their investment more profitable and risky. Securitization facilitating the emergence of the “shadow banking” system foments, simultaneously, bubbles on different segments of a global financial market.

Yet over the past decade this system, or a big part of it, began to lose touch with its ultimate purpose: to reallocate deficit resources in accordance with the social priorities. Instead of writing, managing and trading claims on future cashflows for the rest of the economy, finance became increasingly a game for fees and speculation. Due to disastrously lax regulation, investment banks did not lay aside enough capital in case something went wrong, and, as the crisis began in the middle of 2007, credit markets started to freeze up. Qualitatively, after the spectacular Lehman Brothers disaster in September 2008, laminar flows of financial activity came to an end. Banks began to suffer losses on their holdings of toxic securities and were reluctant to lend to one another that led to shortages of funding system. This only intensified in late 2007 when Nothern Rock, a British mortgage lender, experienced a bank run that started in the money markets. All of a sudden, liquidity became in a short supply, debt was unwound, and investors were forced to sell and write down the assets. For several years, up to now, the market counterparties no longer trust each other. As Walter Bagehot, an authority on bank runs, once wrote:

Every banker knows that if he has to prove that he is worth of credit, however good may be his arguments, in fact his credit is gone.

In an entangled financial system, his axiom should be stretched out to the whole market. And it means, precisely, financial meltdown or the crisis. The most fascinating feature of the post-crisis era on financial markets was the continuation of a ubiquitous liquidity expansion. To fight the market squeeze, all the major central banks have greatly expanded their balance sheets. The latter rose, roughly, from about 10 percent to 25-30 percent of GDP for the appropriate economies. For several years after the credit crunch 2007-09, central banks bought trillions of dollars of toxic and government debts thus increasing, without any precedent in modern history, money issuance. Paradoxically, this enormous credit expansion, though accelerating for several years, has been accompanied by a stagnating and depressed real economy. Yet, until now, central bankers are worried with downside risks and threats of price deflation, mainly. Otherwise, a hectic financial activity that is going on along unbounded credit expansion could be transformed by herding into autocatalytic process that, if being subject to accumulation of a new debt, might drive the entire system at a total collapse. From a financial point of view, this systemic collapse appears to be a natural result of unbounded credit expansion which is ‘supported’ with the zero real resources. Since the wealth of investors, as a whole, becomes nothing but the ‘fool’s gold’, financial process becomes a singular one, and the entire system collapses. In particular, three phases of investors’ behavior – hedge finance, speculation, and the Ponzi game, could be easily identified as a sequence of sub-cycles that unwound ultimately in the total collapse.

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Hyperstructures

In many areas of mathematics there is a need to have methods taking local information and properties to global ones. This is mostly done by gluing techniques using open sets in a topology and associated presheaves. The presheaves form sheaves when local pieces fit together to global ones. This has been generalized to categorical settings based on Grothendieck topologies and sites.

The general problem of going from local to global situations is important also outside of mathematics. Consider collections of objects where we may have information or properties of objects or subcollections, and we want to extract global information.

This is where hyperstructures are very useful. If we are given a collection of objects that we want to investigate, we put a suitable hyperstructure on it. Then we may assign “local” properties at each level and by the generalized Grothendieck topology for hyperstructures we can now glue both within levels and across the levels in order to get global properties. Such an assignment of global properties or states we call a globalizer. 

To illustrate our intuition let us think of a society organized into a hyperstructure. Through levelwise democratic elections leaders are elected and the democratic process will eventually give a “global” leader. In this sense democracy may be thought of as a sociological (or political) globalizer. This applies to decision making as well.

In “frustrated” spin systems in physics one may possibly think of the “frustation” being resolved by creating new levels and a suitable globalizer assigning a global state to the system corresponding to various exotic physical conditions like, for example, a kind of hyperstructured spin glass or magnet. Acting on both classical and quantum fields in physics may be facilitated by putting a hyperstructure on them.

There are also situations where we are given an object or a collection of objects with assignments of properties or states. To achieve a certain goal we need to change, let us say, the state. This may be very difficult and require a lot of resources. The idea is then to put a hyperstructure on the object or collection. By this we create levels of locality that we can glue together by a generalized Grothendieck topology.

It may often be much easier and require less resources to change the state at the lowest level and then use a globalizer to achieve the desired global change. Often it may be important to find a minimal hyperstructure needed to change a global state with minimal resources.

Again, to support our intuition let us think of the democratic society example. To change the global leader directly may be hard, but starting a “political” process at the lower individual levels may not require heavy resources and may propagate through the democratic hyperstructure leading to a change of leader.

Hence, hyperstructures facilitates local to global processes, but also global to local processes. Often these are called bottom up and top down processes. In the global to local or top down process we put a hyperstructure on an object or system in such a way that it is represented by a top level bond in the hyperstructure. This means that to an object or system X we assign a hyperstructure

H = {B0,B1,…,Bn} in such a way that X = bn for some bn ∈ B binding a family {bi1n−1} of Bn−1 bonds, each bi1n−1 binding a family {bi2n−2} of Bn−2 bonds, etc. down to B0 bonds in H. Similarly for a local to global process. To a system, set or collection of objects X, we assign a hyperstructure H such that X = B0. A hyperstructure on a set (space) will create “global” objects, properties and states like what we see in organized societies, organizations, organisms, etc. The hyperstructure is the “glue” or the “law” of the objects. In a way, the globalizer creates a kind of higher order “condensate”. Hyperstructures represent a conceptual tool for translating organizational ideas like for example democracy, political parties, etc. into a mathematical framework where new types of arguments may be carried through.

Conjuncted: Austrian Economics. Some Ruminations. Part 1.

Ludwig von Mises’ argument concerning the impossibility of economic calculation under socialism provides a hint as to what a historical specific theory of capital could look like. He argues that financial accounting based on business capital is an indispensable tool when it comes to the allocation and distribution of resources in the economy. Socialism, which has to do without private ownership of means of production and, therefore, also must sacrifice the concepts of (business) capital and financial accounting, cannot rationally appraise the value of the production factors. Without such an appraisal, production must necessarily result in chaos.