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