Black Box Money


Happy Anniversary of the biggest stock market failure of all time – Black Monday, 19 October 1987.

An appropriate colour for a watershed moment in financial history. All of the financial system is for most, even for the ‘experts’ and alleged ‘economists’, one big black box.

John Lancaster cracks open black box in his book ‘Whoops: Why Everyone Owes Everyone And No One Can Pay”, with countless exhortations to embrace failure especially in the appreciation of the hazardous inscrutability of these new black boxes….

  • “What is this money stuff anyway? I can see its effects – I can thumb a banknote, flip a coin – but what is it actually? What do these abstract numbers stand for? What is the thing being represented? Wouldn’t it be reassuring if it was more like a physical thing and less like an idea? And then the thought fades: money is what it always was; just there, a fundamental fact of the world.”

‘Money’ is essentially a ‘promise’. In fact, some financial instruments are called ‘promissory notes’. American currency has the words ‘promise to pay the bearer’. If you give me something right now, a chicken or a shoe shine, I will give you this piece of paper/metal that is a ‘promise’ to give you something equivalent in the future.

  • “I will gladly pay you Tuesday for a hamburger today” – Wimpy

A major casualty of the credit crisis will be the devaluing of money. Not just in the inflationary sense, which is inevitable as the classic mode of balancing out numbers of promises with numbers of paper pieces outstanding. But more importantly in the ‘trust’ sense. The currency might also say ‘In God We Trust’, but more important than a deity is trust that the piece of paper will actually deliver on its promise. And with the people being bitten, they will be twice shy for some time to come. It’s not just the legal tender that is a black box. The entire economic system is…

  • The free market stopped being one way of arranging the world, subject to argument and comparison with other systems; it became an item of faith, of near mystical belief. In that belief system, the finance industry made up the class of priests and magicians, and began to be treated as such.”

The free market of trade in commerce, like the free market of ideas in science, can be just as adulterated and made dysfunctional by ‘True Believer’ fundamentalists. Where there is ignorance, there is authoritarianism….

  • “[President Clinton’s Campaign Manager James Carville noted] ‘I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.’ But the ordinary elector knows almost nothing about how these markets work and the impact they have. David Kyanston points out that under communism, children from primary school upwards were taught the principles and practice of the system, and were thoroughly drilled in how it was supposed to work. There is nothing comparable to that in the capitalist world. The City is, in terms of its basic functioning, a far-off country of which we know little.”

Lancaster attributes this phenomenon to a broader trend in society of ‘Modernism’ which tends to abstractify everything from music and art to literature and poetry. Abstraction is the what most black boxes are constructed out of. The equivalent of ‘The Waste Land’ or ‘The Rite of Spring’ in economics is the Black-Scholes Equation…

  • Finance, like other forms of human behaviour, underwent a change in the twentieth century, a shift equivalent to the emergence of modernism in the arts – a break with common sense -, a turn towards self-referentiality and abstraction and notions that couldn’t be explained in workaday English.”
  • “The power of derivatives is one of the main things about them – their ability to hedge risk, but also, and more alarmingly, to magnify it. We are a long, long way from a single quote for next season’s wheat crop…Some derivatives involved are actively designed to conceal the real nature of the assets involved – bearing in mind that the assets involved are themselves often debts repackaged and sold on in ‘black box’ structures designed to hide the entities within. The products created are far over the heads of civilians and sometimes, it seems, over the heads of more of the people who buy and sell them.”
  • “[Warren] Buffet was doubly right to compare the new financial products to ‘weapons of mass destruction’ – first, because they are lethal, and second, because no one knows how to track them down.”
  • They had forgotten Murphy’s Law, an important principle of engineering – and not at all the same thing as ‘Sod’s Law’, which is a facetious idea that the worst thing always happens (in French, ‘le loi de l’immerdement maximum’). Murphy’s Law is an engineering principle, and it states that if something can go wrong, it will. So the idea that something will go wrong needs to be built into a machine – how to monitor it, how to fix it and what to have in place as a backup when it fails. The designers of CDO’s [Credit Default Orders] forgot Murphy’s Law”
  • “[Humans] aren’t all that good with numbers in general. We seem to be hard-wired to make certain sorts of mathematical mistakes. This is a profound challenge to the way much of the economics profession sees the world.”

Lancaster talks about the ‘funny smell’ that many astute players smelled when steering clear of this complex instruments. They were too complex to truly dissect what they took issue with, but a side effect of this black box was a distinct stench emanating. Lancaster comments, “Economists no longer have much interest in funny smells.”

Embrace the “funny smells” emanating out of the black box is one lesson of the crisis. If it sounds/smells too good to be true, if it promises to engineer away risk, then that is probably a sign that it is one of the riskiest things you could some across.

  • “About twenty years ago, the visionary climate scientist James Lovelock said that what the Earth needed was the equivalent of a small heart attack. He said that the effect of such an episode is, in an individual’s life, often beneficial, because it forces them to face the fact about themselves and to adopt a more healthy lifestyle. The planet needed something like that, to get humanity’s attention for what we have been doing to it. The earth didn’t get its small heart attack, but the credit crunch is capitalism’s equivalent.”

Black Monday was perhaps one of those heart attacks, but the cardio-vascular system is as weak and clogged as it has ever been which hopefully will be a wake up call for reforms that embrace the inherent system failures and account for them with transparency and accountability.