You are not a Gadget: A Manifesto (18 page)

One of the toughest problems we’ll face as we emerge from the financial crisis that beset us in 2008 is that financiers ought to continue to
innovate in creating new financial instruments, even though some of them recently failed catastrophically doing just that. We need them to learn to do their job more effectively—and safely—in the future.

This is a crucial issue for our green future. As the world becomes more complex, we’ll need innovative financial structures to manage new and unforeseen challenges. How do you finance massive conversions to green technologies that are partially centralized and partially decentralized? How can a financial design avoid catastrophic losses, as massive portions of the infrastructure of the old energy cycle are made obsolete? Battling global warming will require new patterns of development that in turn require new financial instruments.

However, it might be a while before governments allow much in the way of deep innovation in finance. Regulators were unable to keep up with some of the recent inventions; indeed, it is becoming sadly clear that in some cases the very people who invented financial instruments did not really understand them.

So this is our dilemma: How do we avoid putting a lid on innovation in finance after a huge crisis in confidence?

Economics is about how to best mix a set of rules we cannot change with rules that we can change. The rules we cannot change come from math and the state of physical reality at a given time (including such factors as the supply of natural resources). We hope the rules we can change will help us achieve the best results from those we can’t. That is the rational side of economics.

But there is an irrational side to all human quests. Irrationality in a market is found not only in individuals, but in the economists who study them and in the regulators who attempt to steer their actions.

Sometimes people decide to continue to use a technology that disappoints again and again, even one that is deadly dangerous. Cars are a great example. Car accidents kill more people than wars, and yet we love cars.

Capitalism is like that. It gives us the buzz of freedom. We adore it even though it has crashed on occasion. We always pretend it will be the other person who is hurt.

Our willingness to suffer for the sake of the perception of freedom is remarkable. We believe in the bits housed in the computers of the financial world enough to continue to live by them, even when they sting us,
because those bits, those dollars, are the abstractions that help us feel free.

Engineers sometimes take on the inherently absurd task of making a deliberately imperfect technology slightly less imperfect. For example, cars are usually designed to reach ridiculous, illegal speeds, because that makes us feel free—and in addition, they come with air bags. This is the absurdity of engineering for the real world.

So the task at hand has an unavoidably absurd quality. If economic engineering succeeds too well, the whole system could lose its appeal. Investors want to periodically feel that they are getting away with something, living on the edge, taking outlandish risks. We want our capitalism to feel wild, like a jungle, or like our most brilliant models of complex systems. Perhaps, though, we can find a way to keep the feeling while taming the system a bit.

One idea I’m contemplating is to use so-called AI techniques to create formal versions of certain complicated or innovative contracts that define financial instruments. Were this idea to take hold, we could sort financial contracts into two domains. Most transactions would continue to be described traditionally. If a transaction followed a cookie-cutter design, then it would be handled just as it is now. Thus, for instance, the sale of stocks would continue as it always has. There are good things about highly regular financial instruments: they can be traded on an exchange, for instance, because they are comparable.

But highly inventive contracts, such as leveraged default swaps or schemes based on high-frequency trades, would be created in an entirely new way. They would be denied ambiguity. They would be formally described. Financial invention would take place within the simplified logical world that engineers rely on to create computing-chip logic.

Reducing the power of expression of unconventional financial contracts might sound like a loss of fun for the people who invent them, but, actually, they will enjoy heightened powers. The reduction in flexibility doesn’t preclude creative, unusual ideas at all. Think of all the varied chips that have been designed.

Constrained, formal systems can, in some cases, be analyzed in ways that more casual expressions cannot. This means that tools can be created to help financiers understand what they are doing with far more insight than was possible before. Once enhanced analytical strategies are
possible, then financiers, regulators, and other stakeholders wouldn’t have to rely solely on bottom-up simulation to examine the implications of what they are doing.

This premise has proven controversial. Technically inclined people who are enthusiasts for ideas related to “complexity” often want financial instruments to benefit from the same open qualities that define life, freedom, democracy, the law, language, poetry, and so on. Then there’s an opposing camp of shell-shocked people who, because of our recent financial woes, want to clamp down and force finance into easy-to-regulate repetitive structures.

The economy is a tool, and there’s no reason it has to be as open and wild as the many open and wild things of our experience. But it also doesn’t have to be as tied down as some might want. It can and should have an intermediate level of complexity.

Formal financial expression would define an intermediate zone, which is not as open as life or democracy but not as closed as a public securities exchange. The structures in this zone could still be interesting, but they, and their composites, could also still be subject to certain formal analyses.

Would financiers accept such a development? At first it sounds like a limitation, but the trade-offs would turn out to be favorable to the entrepreneurial and experimental spirit.

There would be one standard formal representation of transactions, but also an open diversity of applications that make use of it. That means that financial designs would not have to follow preexisting contours and could be developed in a wide variety of ways, but could still be registered with regulators. The ability to register complex, creative ideas in a standard form would transform the nature of finance and its regulation. It would become possible to create a confidential, anonymous-except-by-court-order method for regulators to track unusual transactions. That would solve one huge recent problem, which was the impossibility of tallying a full accounting of how deep the hole was after the crash, since the exotic financial instruments were described in terms that could be subject to varying interpretations.

The ability to understand the implications of a wide range of innovative, nonstandard transactions will make it possible for central banks and other authorities to set policy in the future with a full comprehension of
what they are doing. And
that
will allow financiers to be innovative. Without some method of eliminating the kind of institutional blindness that led to our recent financial catastrophes, it is hard to imagine how innovation in the financial sector will be welcomed again.

A cooperative international body would probably have specific requirements for the formal representation, but any individual application making use of it could be created by a government, a nongovernmental organization, an individual, a school, or a for-profit company. The formal transaction-representation format would be nonproprietary, but there would be a huge market for proprietary tools that make it useful. These tools would quickly become part of the standard practice of finance.

There would be a diversity of apps for
creating
contracts as well as analyzing them. Some would look like specialized word processors that create the illusion of writing a traditional contract, while others might have experimental graphic user interfaces. Instead of solely outputting a written contract of the usual sort to define a financial instrument, the parties would also generate an additional computer file that would be derived from a contract as part of the guided process of writing it. This file would define the structure of the financial instrument in the formal, internationally standardized way.

Applications analogous to Mathematica could be created that would transform, combine, simulate, and analyze transactions defined in these files.

For example:

• A given transaction could be restated from the point of view of a customer, a third party defining derivatives of it, a regulator, or other parties.
  

• It could also be analyzed within the curved space of an expanding or contracting economy (hopefully encouraging the correction of how granularities—which usually assume a static environment—are defined).
  

• The temporal aspects of the transaction could be analyzed so that indexes and other measurements could be tweaked to avoid artifacts due to inappropriate granularity
  

• A transaction design could be input into simulations of a wide variety of scenarios to help analysts assess risks.
  

• Regulations could be expressed in a more general and abstract way. For instance, if a regulator became curious about whether a particular derivative should be understood as a form of insurance—which should only be allowed if the insurer has adequate reserves—it would be easy to make the necessary analysis. (This function would have prevented much of the current mess.)
  

• It should also be possible to detect the potential emergence of Ponzi schemes and the like within complex networks of transactions that might otherwise fool even those who designed them.
  

• Visualizations or other nonstandard presentations of transactions that would help legislators and other nonspecialists understand new ideas in transactions might be developed.
  

• A tool to help consumers cope with the monetary world might well come from an enlightened NGO or a university. I would hope to see foundations offering prizes for the best visualization, teaching, or planning tools for ordinary people, for instance.