Monday, September 26, 2011

Chaos theory and the Great Recession

The butterfly effect - a good movie and an even more powerful mathematical construct - chaos theory. The situation that exists in today's world seems to conform to only this construct, if at all. They say that there are three main defining aspects to chaos theory, and the way I understand it, those conditions are - 1. Sensitivity or dependence to initial situations or triggers, 2. Mixing or topological transitivity or simply, overlap and finally, the most elegant of them all - density of periodic orbits, or that every point in the system is a finite distance away from a periodic, repeating orbit or simply put, every system is in a precarious state of stability, being just a miniscule distance away from... chaos! Now look at the current economic mess we are in. 

Housing boom, banking boom, loans repackaged, investment banks flourishing, CDOs, passing-the-parcel, the buck stopped, housing bust, CDOs flopped, banks plopped. Policy makers decided not to spare the rod and spoil the child and let Lehman go bust. Condition 1- Sensitivity to initial conditions. The first initial condition of what to do when Lehman was looking to go insolvent - had the reaction panned out differently, the world would have been different today! What policymakers didn't realize then, was that Lehman would take with it the whole financial system and put the world into a form of inexplicable chaos! What with European exposure to Lehman and the wonderful world of CDOs, and who expected AIG, the single largest insurer of all things risky, to face claims on all it's risks? The proverbial black swan was showing it's ugly face almost all over the world at once. And suddenly industry and producers were facing a credit freeze and people like GE were having trouble raising money to run everyday operations. TARP happened, cheap money was given out, but the economy was shaken and risk aversion kicked in. The credit freeze contagion spread and welfare state Europe began to realize how years of condoning mediocrity was doing them in. PIIGS or Portugal, Iceland, Italy, Greece and Spain suddenly found themselves in debts they were unable to pay. Unrest skyrocketed, and people took to the streets in Athens, Tunisia, Syria, Egypt, Libya, Bahrain, and grim fears of war materialized. Condition 2 - Topological transitivity! 
Obama came to power, and people expected the fairy tale to continue and half expected him to wave a magic wand that could rid them of all maladies. But QE 1, 2 and 3 can only do so much if banks are unwilling to lend and people are unwilling to spend! So once upon a time banks lent money to a man with no fixed income and let him realize his dream of a swanky house he couldn't afford. Now, bitten by the shock of a fellow bank going non-existent, every bank started playing safe... perhaps too safe at that! And now, when 'Operation Twist' happened a few days back with lowering long term yields to make the short term yields look more promising, the street took the exact opposite view and believed that long term prospects look grim! Each time a steady state is approached or thought to be approached, we get nudged into yet another unsteady tailspin. Condition 3 - Density of periodic orbits....

And grim as it may sound, the phenomenon of history repeating itself (a manifestation of condition 3) does seem a reality. Lehman was allowed to fail as policy makers wanted to set an example and teach a lesson. Talks in Europe show that no country wants to hurt itself a bit in a bid to save a pal. Will Christine Lagarde let Greece fail in order to teach a lesson on austerity? Unrest began on Athens streets, and spread over to the Middle East and skeletons keep falling out of corrupt Indian closets every day. Fights on streets for jobs is a reality everywhere and civilized society is not any different, except maybe in the absence of fisticuffs and public fights. But if the Transcanada Pipeline controversy or the Keystone Controversy as it is called is anything to go by, with Americans in Nebraska fighting the pipeline that can connect supply from Oil Sands rich Alberta to refineries in the Gulf Coast on grounds that are environmental on the surface and protectionist towards jobs on the inside, it just looks like it is the Great Depression all over again. It took a World War to get the world out saner, more humble and tragically tempered. 

Hope the Butterfly somewhere can flap its wings to preclude that repetition and somehow get us all out of this chaos saner, more humble, more cohesive, more sensible and definitely less greedy!

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