This blog continues the short series on the new book, Navigating Uncertainty: Radical Rethinking for a Turbulent World. In the chapter on Finance and banking, I look at the 2007-08 financial crash and how particular models and regulatory practices created a false sense of security through the practices of risk management, when in fact uncertainty and ignorance prevailed.
As the book notes, “The arrival of high-speed Internet had made financial transactions almost instantaneous, and the old-fashioned style of traders and brokers exchanging across the floor, over the phone or in a bar after work had long gone. Rapid, impersonal trades were the standard, guided by complex algorithms and carried out on computers connected internationally. CEOs, central banks and governments had little clue how everything worked, yet mistakenly trusted the system and the light-touch regulation, while enjoying the profits.
At the centre of this complex web were mathematical models generating operational algorithms that were used to manage such interactions. In the period leading up to the crash, the now notorious Black-Scholes-Merton equation dominated the way financial interactions were understood and a massive derivatives market based on options trading was created.” As the mathematician Ian Stewart explains:
The Black–Scholes equation changed the world by creating a booming quadrillion-dollar industry; its generalisations, used unintelligently by a small coterie of bankers, changed the world again by contributing to a multitrillion-dollar financial crash whose ever more malign effects, now extending to entire national economics, are still being felt worldwide.
John Kay and Mervyn King in their book, Radical Uncertainty, agree. They comment, “models used by regulators and financial institutions, directly derived from academic research in finance, not only failed to prevent the 2007-08 crisis but actively contributed to it.” In particular, macro-economic forecasting models used by central banks tended to fail when major shocks occurred, precisely when they were needed the most.
As the then Bank of England chief economist Andy Haldane commented in 2009, “Processes of securitisation resulted the network becoming complex, dense and opaque, with diversification generating heightened system-wide uncertainty.” The result was the crash. The financial crisis was rooted in what Haldane called “an exaggerated sense of knowledge and control.”
That things were not as bad as they could have been was down to how traders and others in the financial network were able to navigate compounding and cascading uncertainties in real time. What I call the ‘human touch’ – socialised networks – were vital for learning, adaptation and response.
Market systems as social networks
This is the central characteristic of very different market settings, such as livestock markets in the Horn of Africa, western India and southern Europe that I also look at in the chapter, counterposing two apparently very different market/finance systems. They have many similar characteristics (global, highly interconnected, rapid transactions, informal/tacit knowledge) but unlike the global financial system, livestock markets in the Horn are able to maintain reliability in the face of extreme volatility. How? The answer is crucial: this is a socially embedded market network, which can respond to uncertainties and steer away from ignorance.
As the chapter explains for the drylands of northern Kenya, “Central to this complex international market is a network of traders and brokers who source animals from diverse locations across pastoral regions and organise their transport to and subsequent sale in terminal markets. This requires a great deal of collective skill, as the uncertainties faced are huge.
Rainfall variability – made worse by the effects of climate change – affects the production of animals across the rangelands, with frequent droughts reducing the possibilities of offtake or imposing significant mortalities, as during the last few years when rains have failed. Market uncertainties can upset plans as sale restrictions may be imposed due to disease outbreaks or new market regulations.”
Many lessons: re-embedding financial systems in the real world
The chapter concludes, “The lessons from the 2007-08 financial crash are many, but central among them is the importance of recognising how uncertainties are generated through non-linear interactions in complex systems and that social, networked responses are key for navigating uncertainties and confronting ignorance. The radical forms financial deregulation seen during the neoliberal era also made market interactions extremely opaque, adding to the number and speed of interactions, and so the uncertainties generated. Reforms that assumed the management of risk (not uncertainty) and so control – whether through external regulation or clever algorithms –were quickly undermined as diverse uncertainties and forms of ignorance were ignored. Assuming that temporalities were irrelevant was also deeply flawed, and only added to the challenge of responding to extreme volatility.
The disembedding of financial systems from the real economy of production and consumption allowed for accumulation amongst a rich, powerful networked global elite, operating outside and across states. This meant that, in contrast to pastoral settings, complex financial systems became detached from local political-economic contexts, generating a new financialised geopolitical order centred on ‘Wall Street’ (and its equivalents) not ‘Main Street’. Unlike in pastoral areas, where market traders are rooted in local societies, the new financial elite escaped any form of social or political accountability.”
The financial crash was a wake-up call, and (some) thinking in economics and finance is now (re)acknowledging the importance of taking uncertainty seriously. This means that conversations between bankers, financiers, economists and livestock traders in Africa – all of whom must be experts at managing uncertainty – might, the chapter suggests, offer some interesting insights for the future.
This series of blogs gives a taste of the different chapters, but you will have to read the book to get the full picture, as well as all the cases studies, along with the references and footnotes! You can buy the book (or download it for free) through this link: Navigating Uncertainty: Radical Rethinking for a Turbulent World (politybooks.com). Use 20% off discount code SCO20 to buy. And if you are in the UK, the Netherlands, Germany, Switzerland or France, do come along to the first launches in October BOOK: Navigating Uncertainty – Pastoralism, Uncertainty and Resilience – PASTRES (or join online at the IDS event on October 3, sign up here: Navigating uncertainty: Radical rethinking for a turbulent World – Institute of Development Studies (ids.ac.uk)).