Enabling The Financial Crisis

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How responsible is silicon for the current financial crisis?

You may have noticed the world is having a bit of a financial crisis lately.  You may have noticed a lot of fingers being pointed in a lot of directions, and pretty much all those fingers are pointing to one legitimate part of the problem.  The only big error you can really make at this point is to think that just one practice, or group, is the cause of the problem.

One place where the fingers haven’t pointed to too much, yet, are the devices that made it all possible.  Computers (and the communications that tie them together) are literally the life support system of today’s financial system.  Only money itself is more important (and I’m not too sure about that).

Yes, of course there was a financial system long before even the most primitive of computers were built, but compared to today, it was small, even tiny, and it took much more time and effort, human effort, to do much of anything. 

Forty years ago, the New York Stock Exchange faced a crisis, and it wasn’t financial.  It was literally choking on the paperwork generated by daily volume of 10-12 million shares.  They had to close the exchange on Wednesday and reduce the trading hours to catch up on the backlog.  The long-term solution wasn’t just computers, just mostly.  Today, over two billion shares get traded regularly on the NYSE, and almost as many get traded on NASDAQ, which didn’t even exist forty years ago.  Today, trading by humans has largely gone by the wayside, and traders are factoring in the speed of light when figuring out where to put their trading computers. 

Trading stock shares is just the simple stuff.   Financial instruments like securitized loans would hardly be possible without computers.  Financial derivatives wouldn’t be possible at all.  The financial strategies followed by trading firms and hedge funds could not be done without real-time monitoring.

There has been big benefits to all this computerization.  It’s makes financial transactions much less costly and time-consuming, just like the Internet makes communications practically free.  But it’s also like using a 4X4 or a snowmobile to explore the wilderness.  They can get you a lot farther than walking, but also can leave you a lot further from help if you get into trouble. 

During the Cold War, a number of movies were made like this one, in which nuclear war was entrusted to fantasically sophisticated computers, which then proceeded to take over the show.   On the service, in a few ways, we have essentially done that with the financial system.  There’s a few critical differences, of course.  No financial computer network has ever become sentient (we might be better off if they had).  They remain tools, and are only as good as their programming and their data. 

To give one grossly oversimplified example, no financial model ever had “A sizable percentage of our loans that this security/derivative is based on were made using utterly bogus credit information approved by people who make money making loans, regardless of whether they’re good or not.”  No computer program had the assumption, “It is very likely that property values in X, Y and Z are going to drop 25% pretty shortly” built into it. 

The problem is not so much less than perfect computer models, but the implicit faith in such models in making what are very large financial bets by financial companies.  It’s like making sports bets.  You have a system with a track record that lets you pick the winner, say 52% of the time.  You make money, but not enough in your eyes.  So you start borrowing large sums of money so you can make bets twenty or thirty times bigger than you could if you were betting your own money.  This works great so long as that 52% win rate holds up, but should that 52% drop to 48% for any period of time, you’re going to lose all your money quickly.   

What is scary about this crisis is that this isn’t even really the biggest problem.  If all the exotic financial instruments you’ve been buying are based on sophisticated computer models you don’t even pretend to comprehend in detail, and some of the models start going bad, you begin to wonder about the rest of the models and the instruments based on them.  If you have no confidence in how much something you don’t understand is actually worth, you’re not going to pay a lot for it, and you’re likely to sell it for anything you can get for it.  The computers can’t help you to assess the real situation because you think it’s garbage in, garbage out, but they can sure help you sell whatever in an instant.  When everybody starts thinking that way at the same thing, that’s when you get panics and financial collapses, and when everybody starts thinking that way about everything, then you get depressions.  This is why you’re hearing about the U.S. and other governments coming to the rescue; it’s really not to keep Bank A or Stock Fund B from going down the tubes; it’s to prevent everything else from following it, which was beginning to happen, and fast.  

It’s not that these sorts of things haven’t happened before, for much the same reasons.  The difference this time is that computerization and the practices it allows have put the financial system on a hair-trigger, and no one wants to see what happens if that trigger gets pulled.  

However, giving up computers in the financial world would be like giving up cars and trains and planes and going back to horses and carriages.  It’s not going to happen because computers are just human tools enabling human behavior, good, bad, or indifferent.  Like guns, computers don’t kill companies/economies, people do. 

Ed

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