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By Root 918 0

Street, the theories of financial economics provide cover for high leverage and deceptive sales practices for off–balance sheet derivatives. On Wall Street, profits come first and good science second. If some theory, however flawed or out of date, can be trotted out with the right academic pedigree to provide a rationale for risk taking, then that is fine. If politicians and regulators are even further behind the learning curve than Wall Street, then that is fine too. As long as the profits continue on Wall Street, the hard questions will not be asked, let alone answered.

CHAPTER 10

Currencies, Capital and Complexity

“The difficulty lies, not in the new ideas, but in escaping from the old ones.”

John Maynard Keynes, 1935

Despite the theoretical and real-world shortcomings of both the Keynesian multiplier and the monetarist quantity approach to money, these are still the dominant paradigms used in public policy when economic growth falters. One need look only at the Obama stimulus and the Bernanke quantitative easing programs to see the hands of John Maynard Keynes and Milton Friedman hard at work. This persistence of the old school is also one driver of the new currency war, because of the expansion of public debt. This debt can be repaid only with help from inflation and devaluation. When growth falters, taking growth from other countries through currency devaluation is irresistible. Far better solutions are needed.

Fortunately, economic science has not stood entirely still. A new paradigm has emerged in the past twenty years from several schools of thought, including behavioral economics and complexity theory, among others. This new thinking comes with a healthy dose of humility—practitioners in many cases acknowledge the limitations of what is possible with the tools at hand. The new schools avoid the triumphalism of Keynes’s claim to a “general theory” and Friedman’s dictum that inflation is “always and everywhere” monetary.

The most promising new school is complexity theory. Despite the name, complexity theory rests on straightforward foundations. The first is that complex systems are not designed from the top down. Complex systems design themselves through evolution or the interaction of myriad autonomous parts. The second principle is that complex systems have emergent properties, which is a technical way of saying the whole is greater than the sum of its parts—the entire system will behave in ways that cannot be inferred from looking at the pieces. The third principle is that complex systems run on exponentially greater amounts of energy. This energy can take many forms, but the point is that when you increase the system scale by a factor of ten, you increase the energy requirements by a factor of a thousand, and so on. The fourth principle is that complex systems are prone to catastrophic collapse. The third and fourth principles are related. When the system reaches a certain scale, the energy inputs dry up because the exponential relationship between scale and inputs exhausts the available resources. In a nutshell, complex systems arise spontaneously, behave unpredictably, exhaust resources and collapse catastrophically. When you apply this paradigm to finance, you begin to see where the currency wars are headed.

Complexity theory has a strong empirical foundation and has had wide application in a variety of natural and man-made settings, including climate, seismology and the Internet. Significant progress has been made in applying complexity to capital and currency markets. However, a considerable challenge arises when one considers the interaction of human behavior and market dynamics. The complexity of human nature sits like a turbocharger on top of the complexity of markets. Human nature, markets and civilization more broadly are all complex systems nested inside one another like so many Russian matryoshka dolls. An introduction to behavioral economics will provide a bridge to a broader consideration of complexity theory and how underlying dynamics may determine the fate of the dollar