Why do we keep getting wrong in financial regulation: Complicated systems vs complex systems

A nice different speech by Brian Johnson of CFPB.

He asks this one question: Why do we keep getting this regulation bit wrong in finance? Why do we keep having crisis despite so much work on regulation? His answer is we have got the whole approach wrong. He brings concept of complicated systems vs complex systems:

I would submit that one of the major reasons regulators keep “getting it wrong,” so to speak, is that they keep making a categorical error in their approach to regulation. Let me take a minute to explain my meaning. Think about the following two words: complicated and complex. Do you think of these words as synonyms? Or do you assign them different definitions? In common usage, they are interchangeable. But in systems theory, they are profoundly different, and I think understanding this difference should help shape the direction of where we are going with financial regulation.

Consider two examples of what I mean. The first is a space shuttle. What is a space shuttle? It is a sophisticated machine intended to take man into space and return him safely to Earth. There are a couple of million moving parts to a space shuttle4, each finely engineered to demanding tolerances. But when assembled in the correct pattern, they respond to human input in a predictable way. Manipulate its control surfaces, and its glide pattern in descent will respond accordingly. This is an example of a complicated system. The whole is the sum of its parts.

Now consider instead a second example of an equities market. How do we describe this type of system? It consists of millions of independent economic actors, each responding in real time to price movements and other information, as well as the behavior of competing actors. We say that is a complex system, and even more than that, it is adaptive. A complex adaptive system exhibits emergent orders, where, unlike the space shuttle, the whole is more than the sum of its parts.5 Complex adaptive systems also have other attributes. For example, independent actors operating within the system self-organize into patterns. Or, where small changes in initial conditions produce large chaotic changes later.6 And finally, complex adaptive systems are characterized by adaptive interaction, where different actors with bounded rationality interact with others, and as experience accumulates, modify their strategies in diverse ways.7

This was all said by Hayek:

If some of this material appears to some of you as old wine in new bottles that is because F.A. Hayek explored many of these ideas. Indeed, during the Economic Calculation debate command-and-control economists focused on static, equilibrium efficiency concerns and advocated for central planning—that is, they sought to manage the economy as if it were a complicated system. Hayek reoriented the debate to focus on what happens when there are disruptions or changes in the market. He explained how a command-and-control institution of bureaucratic planning fails to adapt to such changes. And Hayek demonstrated conclusively that without the market process, it is impossible for the adaptive process to operate.

Hayek noted in particular that a central planning board would be slower to respond to local changes and eventual responses to such changes would be less refined than market responses. As Hayek put it, the central planning board would be immune to “the particular circumstances of time and place.”8 And because of the very same practical limits to knowledge gathering, the central board would be unable to adapt to ongoing needs and changes in preferences, and ultimately would fail to represent the opportunity cost in final production decisions fully. As Hayek so presciently pointed out, complicated systems and complex adaptive systems present entirely different management challenges.

Johnson ‘s basic premise is we think of finance as a complicated system and keep adding layers of regulation to it. Only to be surprised each time the crisis strikes. Instead finance is a complex system which needs a change in approach as it keeps changing:

The modern regulatory paradigm generally views financial systems as too large and complicated to rely on market ordering. This partly explains why we see tens of thousands of pages worth of regulation in the Federal Register. But is it true that large and complex systems cannot or should not rely on market ordering and market-reinforcing rules to govern financial activities?12

It is an uncontroversial observation that large and complex natural systems like a human body or an ecosystem self-regulate. That is, these systems have inherent qualities that allow them to adapt and evolve in response to exogenous or endogenous changes. There is no central authority dictating these adaptive responses. Yet whenever one attempts to analogize this uncontroversial observation to human institutions,13 one is usually met with skepticism. For example, many believe that as a system becomes larger and more complex, the rules that govern activity within the system must be commensurately large and complex. Though there have been explicit criticisms offered against this belief,14 it is clearly the orthodoxy that has governed the American regulatory environment.

Now, if you accept my distinction between complicated and complex systems, and my conclusion that the two systems cannot be managed the same way, perhaps I can persuade you that one of the reasons financial regulators keep “getting it wrong,” so to speak, is that they keep trying to apply command-and control rules to complex, adaptive markets in an attempt to solve the problem of market instability.

This does not mean no regulation:

On this score, I have a few thoughts. First, I would like to make clear that I am not suggesting that we should not have financial regulations. To the contrary, last fall at a national meeting of consumer advocates, I expressly acknowledged the utility of market-reinforcing regulation.16 I want to recapitulate the main points of that discussion briefly. In my remarks, I argued that the CFPB’s guiding regulatory principle should be animated by a concept I defined as a presumption in favor of consumer choice.

Because markets cannot operate effectively without allowing individuals to shape their lives in the manner they see best, government should respect consumer sovereignty. It should not attempt to replace the consumer’s preferences with its own preferences. That is to say, the legitimate role for government intervention is limited to market-reinforcing, not market-replacing, rules.17

Now, why do I think that the CFPB should focus on reinforcing market activity? Well, because we have a tremendous amount of evidence demonstrating that markets improve the lives of all people, most importantly the least-well-off among us. In some parts of the world, including the United States, average income has risen from 3 dollars a day (in present day prices) two centuries ago to over 130 dollars a day today, a 4,000 percent increase.18

The areas of the world that have not seen similar improvements in human life have not relied on markets for as long as the United States or instead chose a command and control approach.19 Indeed, all one has to do is turn on the news today from Venezuela to see the type of damage socialist economies do to their people.

Hmm…

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