In the Monday, January 26th Oregonian, there was a fascinating article discussing proposed legislation to create an overall oversight body regulating the financial system-as-a-whole, as opposed to the system-as-parts. It is a badly needed addition, with a fatal flaw: they're talking about giving it to the Fed, which is too deep in the system to view it objectively.
From "Overseer proposed for financial system" by Neil Irwin and Binyamin Appelbaum:
The legislation envisioned by House Financial Services Committee Chairman Barney Frank, D-Mass., would put the Fed, or less likely another government agency, in charge of protecting the stability of the entire system, Frank and other congressional sources said.
An abundance of federal agencies regulate the financial industry. But no agency is responsible for understanding or containing risks affecting the financial system as a whole. In fact, none even has a complete picture of the financial markets.
Under Frank's legislation, the new regulator would likely be given the power to gather information about the inner workings of banks, investment firms, insurance companies, hedge funds, and any other entity big enough or so intertwined with other compannies that it creates the risk of systemic collapse.
I'm sure that Rep. Frank is a very smart person. Unfortunately, that doesn't prevent people from failing to recognize, let alone predict, the dynamics of complex systems. Wherever a system has reinforcing feedback loops, counteracting feedback loops, and time delays in the interactions between its components, some very counter-intuitive behavior can result at the level of the system-as-a-whole.
One of the characteristics of complex dynamic systems is that the whole is not, in fact, equal to the sum of its parts. Indeed, whole new properties can emerge at the level of the system-as-a-whole that don't exist in any amount in any of the components, such as flocking behavior of birds: a flock-as-parts (each bird) has to turn its whole body to change direction, but the flock-as-a-whole is able to change direction just by changing leaders -- without having to keep the same birds in the same order of front, sides and rear -- completely unlike how a bird has to keep its head, wings and tail in a particular order.
One of the characteristics of humans is that we're irrational. It's adaptive for us to develop and follow simple habits of mind to deal with an overwhelming world, but it makes us vulnerable in situations where those instinctive heuristics can be exploited by the unethical. We're also susceptible to having our ego self-defense routines settle on sub-optimal techniques (character flaws) that have the appearance of being fast and effective, without noticing their indirect, long-term drawbacks.
For example, from a 1995 speech by Charlie Munger -- Warren Buffett's longtime right-hand man at Berkshire Hathaway -- one of the most common causes of human misjudgment is "bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won":
Well what I'm saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can't get in. The human mind has a big tendency of the same sort. And here again, it doesn't just catch ordinary mortals; it catches the deans of physics. According to Max Planck, the really innovative, important new physics was never really accepted by the old guard. Instead a new guard came along that was less brain-blocked by its previous conclusions. And if Max Planck's crowd had this consistency and commitment tendency that kept their old inclusions intact in spite of disconfirming evidence, you can imagine what the crowd that you and I are part of behaves like.
And of course, if you make a public disclosure of your conclusion, you're pounding it into your own head. Many of these students that are screaming at us, you know, they aren't convincing us, but they're forming mental change for themselves, because what they're shouting out is what they're pounding in. And I think educational institutions that create a climate where too much of that goes on are...in a fundamental sense, they're irresponsible institutions. It's very important to not put your brain in chains too young by what you shout out.
And that's very interesting, you see, because I believe that organizations are metapeople: complex dynamic systems that are made of people, and that transcend their human components due to being more (or in committees, sometimes less) than the sum of their parts. So, I look for situations where the metaperson-as-a-whole exhibits a recognizable trait of human people as an emergent property due to the interaction of its human components paralleling the interaction of parts of a human mind, without the metaperson-as-parts (individual humans) necessarily exhibiting that trait themselves.
And whaddaya know? The organization-as-a-whole has a kind of misjudgment -- Persian messenger syndrome -- that works just like commitment tendency or denial, but is an incentive-caused bias when considered from the perspective of the organization-as-parts (the human people):
And all these psychological tendencies work largely or entirely on a subconscious level, which makes them very insidious. Now you've got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should've seen Bill Paley in his last 20 years. (Paley was the former owner, chairman and CEO of CBS; see http://www.kcmetro.cc.mo.us/... for his bio.) He didn't hear one damn thing he didn't want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn't want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.
And now the Persian messenger syndrome is alive and well. I saw, some years ago, Arco and Exxon arguing over a few hundred millions of ambiguity in their North Slope treaties before a superior court judge in Texas, with armies of lawyers and experts on each side. Now this is a Mad Hatter's tea party: two engineering-style companies can't resolve some ambiguity without spending tens of millions of dollars in some Texas superior court? In my opinion what happens is that nobody wants to bring the bad news to the executives up the line. But here's a few hundred million dollars you thought you had that you don't. And it's much safer to act like the Persian messenger who goes away to hide rather than bring home the news of the battle lost.
Now the Federal Reserve is a component of the financial system, just as a messenger was a component of an ancient Persian military. So, it stands to reason that if the Federal Reserve were attempting to regulate the system that it's part of, then it could suffer a metapersonal form of the incentive-caused bias that individual human people suffer, creating unnecessary, avoidable misjudgment in that regulation. Put another way: just as you need an outside auditor to provide a fresh, independent perspective to a corporation's accounts, so do we need an outside regulator to provide a fresh, independent perspective to the financial industry, if we're going to try to regulate the system-as-a-whole.
That, of course, raises the question: what's big and independent enough to provide correction to the financial system-as-a-whole? Not even the President or Congress are that independent, since they're so dependent on campaign contributions from that powerful industry; and it isn't a proper role for the Judiciary. So, that only leaves the ultimate source of political power in these United States, We the People, of whom the entire financial system is only one small part.
I propose the creation of a relatively independent agency, like the U.S. Government Accountability Office, to monitor our financial system-as-a-whole for systemic risks, and report their findings directly to the American people. A combination of bankers, systems scientists and digital animators would likely suffice to model the complex dynamic behavior of the financial system and communicate it in a viscerally obvious, immediately graspable way, that could then be uploaded to YouTube. From there, it would be our collective responsibility as a people to decide what to do with that information; and if we chose poorly, then at least we would've chosen for ourselves.