Monday, March 21, 2011

Chaos and complexity in financial markets and nuclear meltdowns

I trust that my friend and colleague John Young will not mind my passing on his email to the Chaos and Complexity Seminar group to which we both belong at the Univ. of Wisconsin:
The NYT article "Derivatives, as Accused by Buffett"(Here is PDF of Buffett's testimony before the Financial Crisis Inquiry Commission) has words that translate into our lingo of Chaos (produced by strong signals interacting nonlinearly) and Complexity (many coupled degrees of freedom).  Excerpts:

The problems arise, Mr. Buffett said, when a bank’s exposure to derivatives balloons to grand proportions and uninformed investors start using them. It “doesn’t make much difference if it’s, you know, one guy rolling dice against another, and they’re doing $5 a throw.

...and Nonlinearity
But it makes a lot of difference when you get into big numbers.” What worries him most is the big financial institutions that have millions of contracts. “If I look at JPMorgan, I see two trillion in receivables, two trillion in payables, a trillion and seven netted off on each side and $300 billion remaining, maybe $200 billion collateralized,” he said, walking through his thinking.

...and High Amplitude Chaos
“That’s all fine. But I don’t know what discontinuities are going to do to those numbers overnight if there’s a major nuclear, chemical or biological terrorist action that really is disruptive to the whole financial system.”

And, Floyd Norris offers an  interesting article that expands on this last point in last Friday's NYTimes, noting how there was general acceptance of the idea that regulators had developed sophisticated risk models to prevent a disaster in both the financial and nuclear power industries. They both were wrong.

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