High Finance is Similar to Warfare

link here to article

This article requires a thoughtful read but it makes several very important points that explain our recent financial crisis and predicts the next one that is sure to follow in the US, since our government has decided not to limit the destructive behavior that is implicit in the system.

One of the important insights in this article is that complexity is central to financial firm rent seeking behavior. Profits are limited in an efficient market because both parties to a transaction have equal knowledge. Therefore, banks create financial products that are opaque and complex. For a simple example, read your credit card agreement. It is incomprehensible to most people and lots of money was spent on legal efforts to make it that way. The banks have protected themselves with the agreements and the consumer is taking unknown risks. This is common to even more complex instruments such as CDO's and other derivatives that bankers sell to supposedly sophisticated customers.

The problems with complexity, which Finance creates in order to harvest risk as excess profit, is that it creates unknown unknowns. That is, complexity does not simply amplify risk, it creates unanticipated risks. It is even more of a problem when the players in the system are tightly coupled as we observed in the last crisis. Problems at Lehman, for example, created problems with all of its counterparty's which led to unanticipated problems elsewhere. It also means that a process moves forward faster than we can analyze and react to it. Decisions had to be made quickly and not all of them were good decisions.

Warfare is a complex system that has destruction as its endpoint. Once the war begins both sides have set in motion a game that can only end by the capitulation of one of the parties that must accept defeat. The US, for example, is unable to extract itself from a war against terror which is not a state that can be destroyed. It cannot stop the war without admitting defeat and suffering the political consequences. Our financial system is similar to warfare in the sense that it is predicated on complexity and tight coupling which leads to unanticipated risks that make destruction likely. It is only able to continue in its rent seeking forms of complexity because the state is there to rescue it.