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A Complex World

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The world is becoming more complicated.

While it is cliche, we do live in an age of information overload. As I’m writing this, millions of Americans are experiencing an example of this as they struggle to make the deadline and file their taxes with the Internal Revenue Service. Click here to see Title 26 of the Internal Revenue Code. It comes in at over 10,000 pages. It obviously didn’t start that size; there is no way a document of this size could be hand-scribed or typeset.

It is one thing for the quantity of information to increase, but it is another for the nature of information to change. Not only is the amount of information growing exponentially, but it is becoming increasingly interconnected and tangled at the same time, into something I like to call Hyper-Complexity. I believe you will find no better or timelier example of this than the financial industry, specifically derivatives, their markets, and their failings.

The Collateralized Debt Obligation (CDO)—a financial instrument that serves as a perfect example of our changing definition of what product means. Once easy to touch, feel, buy, and understand—like a hammer, teapot, or lawnmower—a product today has evolved into a system of objects, services, and networks where the ratio of tangibility to intangibility is changing dramatically. The CDO, and in particular the synthetic CDO, is such a great example derivative because its value is “derived” from insurance-like instruments on loans in pools of collateral. It is several steps removed from anything “tangible.” Further complicating the matter, a CDO is sliced into tranches, which are sold to various investors, some of whom repackage them into new CDOs, which are sliced and sold again, and so on…

A useful whiteboard demonstration by Marketplace Senior Editor Paddy Hirsch can be seen here.

Derivatives are so complicated that until recently, only a small portion of the population new about them, and an even smaller potion could actually deal with them. In fact, many derivatives were used expressly because of their opacity, which kept them out of the hands of regulators, credit-default swaps can be an example of this.

Though conceived of as a product, a synthetic CDO is actually a series of fractional ownerships and valuations of fractional ownerships and valuations of fractional ownerships and valuations and so on…

While it is fine for complexity to exist—and it always will—it is important for us to know when we have a stake in it. This was the problem, we didn’t know how dependent our financial system had ultimately become on rising housing prices and sub-prime mortgages. The institutions that handle our pensions and investments wound up owning theses derivatives. Most of us have enough trouble figuring out how to manage our own 401k, what is an individual to do when the entire industry that handles 401ks takes on an endemic problem, and eventually collapses? And the collapse is not just limited to institutional investors, nor just the financial industry. It is not even limited to the local economy—but to our global economy.

A relatively small increase in the default rate of U.S. sub-prime mortgages cascaded into a catastrophic wave across the global economy in a manner few could predict. Even former Federal Reserve Chairman Alan Greenspan, generally held as one of the most accomplished, even prescient, central bankers stated that he was “shocked” by the dramatic failure of credit markets in the ensuing financial “credit tsunami.”

This reaction encapsulates why the financial system is a great example of hyper-complexity, but it is certainly not the only one. Economics happens to be my personal interest, but there are many other complexities at comparable scales, even ones threatening systemic failure. Medicare and Medicaid come to mind. But not all complexities are dangerous, of course, and a number of progressive responses have been made towards both the treacherous and benign sort.

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