Reflecting Trichet

A speech by Jean-Claude Trichet at the International Capital Market Association’s Annual Conference has received considerable comment - see here for instance for Alea. I'd like to focus on just two aspects in a long speech. First, leverage:

The challenge lies in preventing the system from feeding on itself through a spiralling process of leveraging...

Abundant liquidity, financial complexity [and] financial players’ incentive structures contrived a convergence of mechanisms that resulted in the upward spiralling of asset prices, further leveraging, increasing complexity and shrinking transparency.

The combination of leverage and complexity is a massive concentrator of model risk. Simple leverage is easy to spot: my broker won't let me buy stock on margin with a 1% haircut. But a tranche of a CDO-squared financed via repo could have a much higher leverage than 100:1. Complexity, then, can hide leverage and it can make modeling the true return distribution difficult or impossible: just because you can structure something does not mean that you should, as Bankers' Trust found out with Gibson's Greetings and Libor-squared swaps.

Second, ECB open market operations:

The first response of the Eurosystem during the turmoil was to try to keep very short-term money market rates near policy rates through more active liquidity management. With this objective in mind, the ECB adjusted the distribution of liquidity supply over the course of a maintenance period, by increasing the supply at the beginning of the period and reducing it later in the period (the so-called frontloading). The average supply of liquidity remained unchanged over the whole reserve maintenance period, in line with the Eurosystem’s aim to provide to the banking system over each maintenance period the exact amount of total liquidity it needs to fulfil its liquidity deficit. The average size of the Eurosystem’s refinancing operations for the maintenance periods since August 2007 remained at around €450 billion, as in the first semester of 2007.

This is remarkable -- and it makes the point beautifully that is is not the supply of cash that has been important in central bank financing operations, but rather guaranteed funding for illiquid assets. The ECB has indeed been remarkably liberal (by the standards of other central banks pre Crunch) in the collateral it permits at the window, and so it did not need to explicitly manipulate liquidity premiums the way the FED did.

Grand Theft Banking

The next instalment of the popular computer game Grand Theft Auto is out today (or, for you really hardcore gamers, midnight yesterday). Its launch prompts me to consider how gaming could help finance, beyond the extra carry from all of those copies of the game bought on credit cards. So how about this: design a game that's the financial system. It has deposit takers, hedge funds, investment banks, pension funds, the lot. It has a diversity of different asset classes too with real time prices. It also has shareholders, depositors, deposit protection, regulation, the interbank market, whatever you want. Your mission, player, is to set the regulations to prevent bubbles, protect depositors, allow moderate growth, and prevent moral hazard. Covertly of course the BIS will be monitoring your progress and any really good ideas get put into Basel 3.

Levels of abstraction

A review by Jerry Fodor in the LRB (of Consciousness and Its Place in Nature by Galen Strawson) brings to mind an issue I've been meaning to write about for ages: the importance of a tall tower of abstraction for some kinds of emergent behaviours.

Fodor says:

The third of Strawson’s leading theses is a good deal more tendentious than the first two; namely, that emergence isn’t possible. ‘For any feature Y of anything that is correctly considered to be emergent from X, there must be something about X and X alone in virtue of which Y emerges, and which is sufficient for Y.’

Assuming for a moment this is a correct account of Strawson's views (I haven't read the book), this is an error, and a common one for people who have not studied systems that have a lot of different levels. Let me try to explain.

How many different levels are there in thinking about reading this post? There's the level of your hardware: transistors and gates. There's the level of hardware design: functional modules and so on. In fact (and I'll skim this part as this isn't the hardware blog) there are three or four levels here, roughly going from thinking about groups of 10-20 transistors to thinking about blocks of hundreds of thousands. Microcode runs on this, so now we are at the hardware/software boundary. Beyond this is the microcode interpreter, instruction optimisation, pipelining and so on. Then up to true machine code, as spit out by a compiler. From there we move up to programming languages. Finally there's your browser and it's internal architecture.

No one understands all of this in detail. A good hardware designer might span the five or six levels of abstraction needed to design a working chip, but most working within one or two levels with some knowledge of the ones above and below. A good software designer might occasionally be willing and able to delve into the compiler output -- very occasionally. But it's just too hard to understand all of the ten or more levels involved in something as simple as a web browswer running on a modern PC. Its behaviour might be determined by its code which in turn relies on an implementation in machine code running on a pipeline processor implemented using... but it might as well be emergent as far as any single person knows.

Now suppose that there are a lot more levels of abstraction involved in a brain than in a PC. We have no idea whether this is true or not, but certainly there is a big gap between the detailed hardware as revealed by neurophysiology and the architecture conjectured by cognitive psychology. It could be that in order to understand that gap we need not one or two levels of abstraction but twenty. Consciousness could be a feature of a program X running on Y running on Z running on A and so on down a long, long way. Just because you can't see how a bunch of transistors is able to grant you access to www.hornyyoungphilosophers.com (register this now if it hasn't gone already - it has to be a money spinner) doesn't mean they can't - just that it is too hard for any single person to understand all the steps necessary for it to happen.

Fodor's article is excellent and it really makes me want to read Strawson's book. But he posits something that seems at least unnecessary (although it may well be true): a law of emergence. Perhaps we don't need it simply because emergence can be like a good joke -- it takes a lot of setting up, and all the pieces are needed to make it work, but once you have all those pieces, the punch line is pretty much inevitable.