an evolutionary approach to financial history

An Evolutionary Approach to Financial History

Gresham Special LectureJune 2, 2009

The Economist said it

“It is a Darwinian world.” (Economist, February 16, 2008)

Tony Ryan said it “Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others.” (Assistant Secretary of the Treasury for Financial Markets Anthony W. Ryan before Congress in September 2007)

Goldman Sachs said it

“The Evolution of Excellence”(Conference in London, November 2005)

Darwin himself intuited it

• On the Origin of Species (1859) partly inspired by Malthus’s Essay (1798)– “Being well prepared to

appreciate the struggle for existence … it at once struck me that under these circumstances favourable variations would tend to be preserved, and unfavourable ones to be destroyed. Here, then, I had at last got a theory by which to work.”

– “principle of divergence”—from Smith’s division of labor

Thorstein Veblen proposed it

“The economic life process [is] still in great measure awaiting theoretical formulation” (“Why is Economics Not an Evolutionary Science?” Quarterly Journal of Economics (1898))

Schumpeter hinted at it“This evolutionary ... impulse that sets and keeps the capitalist engine in motion comes from ... the new forms of industrial organization that capitalist enterprise creates. … The ... same process of industrial mutation … incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.” (Capitalism, Socialism and Democracy (1943), pp. 80-4)

Some economists have tried it

• Alchian, A.A. (1950) “Uncertainty, evolution and economic theory”. Journal of Political Economy 58: 211–222

• Nelson, R.R. and Winter, S.G. (1982) An evolutionary theory of economic change. Harvard University Press, Cambridge, MA

And perhaps its time has come• Andrew Lo at MIT: “Hedge

funds are the Galapagos Islands of finance ... The rate of innovation, evolution, competition, adaptation, births and deaths … occurs at an extraordinarily rapid clip.”

• “As with past forest fires in the markets, we're likely to see incredible flora and fauna springing up in its wake.”

• “Adaptive markets”

But Hilferding still looms large

• The legacy of Rudolf Hilferding’s Finanzkapital (1910)

• Concentration and consolidation in financial services as an inexorable process of exploiting economies of scale and scope

An evolutionary process?

Evolution as seen by Citigroup

A real evolutionary process

Evolution as seen by Darwin

The evolutionary analogy• Competition for finite resources – customers, clients• Potential for spontaneous mutation – innovation• Mechanism for natural selection – through the

market allocation of capital and human resources – and possibility of death in cases of under-performance (differential survival)

• Scope for speciation and hence sustained bio-diversity

• Scope for species extinction • Genes – institutional memory of business practices

Recent trends in financial evolution

• Instruments– Mortgage-Backed

Securities– Other Asset-Backed

Securities– Collateralized Debt

Obligations– Collateralized Loan

Obligations– Derivatives

• Institutions– Hedge funds– Private equity

partnerships– Sovereign wealth funds– Conduits– Structured Investment

Vehicles (SIVs)– Bond insurers– “Shadow banking”

Source: Oliver Wyman

Source: Oliver Wyman

The first hedge fund was set up in the 1940s to allow savvy investors to bet against stocks by taking so-called “short” positions.

The Long Term Capital Management debacle didn’t stem the rise

Source: Hedge Fund Research

Hedge fund assets and positions

Source: Lo Testimony (2008)

Asset backed securities

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Ginnie Mae Fannie Mae Freddie Mac

0

500

1,000

1,500

2,000

2,500

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Auto Credit Card Equipment Home Equity Manufacturing Student Other

Mortgage-backed and asset-backed securities in the U.S. ($bn)

Derivatives

0

50,000

100,000150,000

200,000

250,000

300,000350,000

400,000

450,000

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

No

tio

nal

Am

ou

nt

Ou

tsta

nd

ing

($ B

N)

Interest rate contracts Foreign exchange contracts Equity-linked contracts

Commodity contracts CDS Other

Over-the-counter derivatives outstanding ($bn)

Source: Oliver Wyman

The differences (part 1)

Eating and sex

• In finance, mergers and acquisitions can lead directly to mutation– Unlike in the natural world, where it’s just plain eating

when one organism ingests another• In finance, there’s no counterpart to the role of

sexual reproduction in the animal world– Though there may be asexual reproduction, as when

people leave Goldman to set up multiple hedge funds• In finance, most mutation is conscious innovation,

rather than random change– So it’s more a Lamarckian not a Darwinian process

The differences (part 2)

Man-made catastrophes

• Sudden environmental changes can render certain evolved traits disadvantageous where previously they had been advantageous, and vice versa

• But financial disruptions are unlike asteroid strikes and ice ages because they are endogenous not exogenous– Great Depression of the 1930s– Great Inflation of the 1970s– “Great Repression” of the 2000s

The differences (part 3)

Intelligent (?) design

• In the natural world, there are no regulators; in finance there is supposed to be “intelligent design”

• But regulators focus on consumer protection and systemic risk, not optimizing evolution

• Most regulations have the effect of shutting the stable door after the horse has bolted

• The risk is that regulation impedes or distorts natural selection

A brief history of the crisis

Global imbalances ...Current account balances as percentages of global GDP

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Oil exporters

Emerging Asia

Japan

Euro Area

United States

... and monetary policy errors ...

... and excessive leverage ...US sectoral debt

as a % of GDP

0

20

40

60

80

100

120

1974 1979 1984 1989 1994 1999 2004

Households

Non-financial Business

All Government

Financial Sectors

... and financial engineering ...ABX.HE.AAA.07-2 (20 MBS)

High 99.33 Low 23.1 Coupon Maturity 25JAN38

“In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A.”

... caused a property bubble Case-Shiller national indices, annual rate of change, 1988-2008

-25

-20

-15

-10

-5

0

5

10

15

20

25

Janu

ary

1988

Janu

ary

1989

Janu

ary

1990

Janu

ary

1991

Janu

ary

1992

Janu

ary

1993

Janu

ary

1994

Janu

ary

1995

Janu

ary

1996

Janu

ary

1997

Janu

ary

1998

Janu

ary

1999

Janu

ary

2000

Janu

ary

2001

Janu

ary

2002

Janu

ary

2003

Janu

ary

2004

Janu

ary

2005

Janu

ary

2006

Janu

ary

2007

Janu

ary

2008

Composite-10

Composite-20

… rendering some big banks insolvent

Source: Financial Times

We’re avoiding the 1930s …

... with monetary expansion ...

… and fiscal stimulus

Inflation v. deflation• “A policy mistake made

by some major central bank may bring inflation risks to the whole world ... As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies’ devaluation risks may rise.” (Chinese Central Bank, quarterly report)

Output gaps (IMF) for • Japan -8.0%• Germany -5.8%• UK -5.5%• Italy -5.1%• France -4.5%• Canada -4.3%• U.S. -4.1%

It’s Godzilla v. King Kong

What happened in the Thirties

What’s happening today

A case of arrested evolution?

A last word from Schumpeter“This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted. ... An indiscriminate and general increase in credit facilities means simply inflation ... [which] destroys that measure of selection which can still be ascribed to the depression, and burdens the economic system with ... those firms that are unfit to live.”Joseph Schumpeter, Theory of Economic Development (1934)

Conclusion

• As a metaphor, evolution offers better insights into the processes driving financial history than models of concentration derived from Hilferding

• The financial world does appear to be characterized by (Lamarckian) mutation and (Darwinian) natural selection

• But “intelligent design” by legislators and regulators impedes the evolutionary process

• Schumpeter’s view still stands: “creative destruction” is integral to economic evolution