1. Grip on Complexity and Uncertainty OECD-Paris 16th January 2015 Lex Hoogduin University of Groningen, Duisenberg School of Finance and GloComNet 1

2. Introduction Complexity of the economy and uncertainty of the future should be taken into account to improve (understanding of) supervision/governance of the economy/financial sector Requires a different paradigm from current mainstream economics Requires different methods; leads to different pretence for economics; leads to different way of conducting policy/supervision and to different policies 2

3. Agenda 1. Replacing two core assumptions of mainstream economics 2. Broad outline of the complexity and uncertainty paradigm 3. Grip on complexity: a research agenda for the financial system 3

4. 1.Two core assumptions of the mainstream (1) A. The assumed knowledge/information/data available to economic agents Distinction between risk and uncertainty (cf. Keynes 1921 and Knight 1921) Risk: all possible outcomes of a decision can be known and listed 4

5. 1.Two core assumptions of the mainstream (2) Probability calculus can be applied and has a solid foundation Mainstream economics: economic agents face a risky future This concept underlies: modern mainstream finance (Black/Scholes, CAPM,EMH, etc) 5

6. 1.Two core assumptions of the mainstream (3) Modern risk management (VAR, ES, etc) Arrow/Debreu model, DSGE model, RBC model The use of rational expectations (RE) Basel III framework and supervisory view 6

7. 1.Two core assumptions of the mainstream (4) But: in making economic decisions it is logically impossible to list all potential outcomes Logical argument: economic agents cannot know now what they will discover/learn in the future (see also Popper) Still, discoveries/learning in the future may impact the outcomes of decisions taken now 7

8. 1.Two core assumptions of the mainstream (5) Therefore, not all potential outcomes can be listed In addition: consequences of decisions by an economic agent may depend on what many, even unknown, other agents will decide, based on their partly private information and knowledge It is impossible for an agent to collect and process all this information, to use it in his own decisions, while taking into account how other agents will respond to that, his response to it, and so on 8

9. 1.Two core assumptions of the mainstream (6) Therefore, the future is not risky, but (fundamentally) uncertain The future is unprestatable (cf. Kauffman) Economic decisions cannot be seen as computable optimising problems In a risky future: money, finance, credit, financial capital and debt play no causal role in the real economy 9

10. 1.Two core assumptions of the mainstream (7) No financial cycles and crises Liquidity has no role to play No bankruptcies No competition No innovations No role for laws, norms, conventions and institutions 10

11. 1.Two core assumptions of the mainstream (8) B. The assumption about the distribution of knowledge and information among agents and the role of their interaction in explaining the outcome of the economic process There is a great dispersion of knowledge and information among economic agents The economic and financial system consist of heterogenous agents who interact pursuing their own objectives 11

12. 1.Two core assumptions of the mainstream (9) This point was early and thoroughly made by Hayek (CW 2014, forthcoming) Impossible to collect all knowledge/information/data present in the economy at one central point Since 1980s development of complexity science covering complex systems in many fields (Santa Fe Institute) In mainstream economics: little heterogeneity (representative agents) 12

13. 1.Two core assumptions of the mainstream (10) Interconnectedness and structure of the network of the economic/financial system are no determinants of economic outcomes 13

14. 2.Outline of the Uncertainty and Complexity paradigm (1) Prediction of the future is difficult, if not impossible Patterns within organized complexity provide language and basis for understanding the economic and financial process Emergent behaviour, e.g. competition, innovation, financial cycles and crises, growth, inflation and deflation Causality running not only from micro to macro, but both ways 14

15. 2.Outline of the Uncertainty and Complexity paradigm (2) Power laws rather than normal distributions; clustering; cumulative change; positive feedback mechanisms; Black Swans Sudden transitions, tipping points, non-linear dynamics Evolutionary development: future is not there to be discovered, but is shaped by/emerges from the (inter)actions of agents on the basis of their expectations of that future and their confidence therein Central role of entrepreneurship and leadership in that context 15

16. 2.Outline of the Uncertainty and Complexity paradigm (3) The future cannot be predicted, but it can be imagined (cf. Shackle). Expectations are drivers of economic developments, rather than passive or an equilibrium condition All the phenomena that do not have a proper role in a risky world fall into place in a world where agents face uncertainty Liquidity in particular can be seen as a means to keep options open in a world where surprises can and will always happen and where there are unintended consequences of actions and policies 16

17. 2.Outline of the Uncertainty and Complexity paradigm (4) Pretence: To understand, rather than to predict To navigate and adapt rather than to control Deal with uncertainty and complexity rather than trying to reduce it Acting in the face of complexity and uncertainty Piecemeal social engineering rather than grand designs 17

18. 2.Outline of the Uncertainty and Complexity paradigm (5) Emphasis in policy on creating the right conditions for desired outcomes to emerge rather than on bringing about those outcomes; role of norms in economic policy in that context Order rather than equilibrium Focus on ever evolving order (process) rather than end-point (equilibrium) Focus on diversity rather than diversification Importance of resilience; slack/buffers;redundancies Tools (multidisciplinary and pluralistic): Decision-making under complexity and uncertainty (Post-Keynesian, (Neo-) Austrian and psychological theory); online course at www.futurelearn.com, starting 19th January www.futurelearn.com 18

19. 2.Outline of the Uncertainty and Complexity paradigm (6) Graph/network theory Agent-based modeling, including cellular automata Gaming Non-linear dynamics Experiments Behavioural economics Historical method/path dependency/locking-in phenomena Institutional economics 19

20. 3.Research agenda Grip on Complexity(1) Research project under the title “Grip on Complexity” One of the sub projects: how to deal with/get grip on the complex financial sector? Would like to develop this into an international research hub on this issue 20

21. 3.Research agenda Grip on Complexity (2) There is potentially a very long and fruitful research agenda Both theoretical/conceptual and immediately policy relevant issues can be addressed What could be on the agenda? A non- exhaustive list. Topics may be added and deleted. Choices have to be made 21

22. 3.Research agenda Grip on Complexity(3) Role of capital and liquidity Data strategy for supervisors Impact of Vickers/Volcker/Liikaanen in a network model Central clearing implications in a network model Understanding financialisation and its impact (the Great Finanical Expansion of the past decades) Impact of separation of retail and investment banking 22

23. 3.Research agenda Grip on Complexity (4) Impact of limiting the size of banks Impact and design of resolution regimes The supervisory strategy: simplicity and norms in a complex system? Competition, innovation and growth Shadow banking The evolution of a bank or market based financial system 23

24. 3.Research agenda Grip on Complexity (5) The role of diversity vs diversification The impact of quantitative risk management on the development of the financial system The impact of modern portfolio theory and asset managers on the development of the financial system Design of stress tests Macroprudential policy, monetary policy and their interaction 24

25. Conclusion Also setting up a network (GloComNet) for research, education and consultancy with respect to complexity and uncertainty Intention to use GloComNet platform as a “vehicle” for the research project “Grip on Complexity” THANK YOU FOR YOUR ATTENTION 25