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An Evolutionary Approach to Financial History. Gresham Special Lecture June 2, 2009. The Economist said it. “It is a Darwinian world.” ( Economist , February 16, 2008). Tony Ryan said it.
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An Evolutionary Approach to Financial History Gresham Special Lecture June 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”
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 Mortgage-backed and asset-backed securities in the U.S. ($bn)
Derivatives Over-the-counter derivatives outstanding ($bn) Source: Oliver Wyman
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
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
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
... 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.”
… rendering some big banks insolvent Source: Financial Times
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%
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
