It is by now common wisdom that our current financial crisis is due in large part to misplaced incentives in our financial system. Analysts and fund managers were rewarded for short-term thinking and risk-taking. If we can rework our financial system to reward long-term, careful planning, it is often argued, we can avoid collapses like this in the future.
While I agree that misplaced incentives were a fundamental problem, the question of how to change this is rather more deep and complex than I think many people realize.
Our economy is, of course, an evolutionary system. Successful businesses grow in size and their practices are imitated by others; unsuccessful businesses vanish. This process has led to many good business practices, even in the financial sector.
However, evolution does not always yield the best outcomes, in biology or in economics. Our recent crisis illustrates two key limitations of evolutionary systems, limitations which allow bad ideas to evolve over good ones.
The first problem has to do with time lags. Suppose Financial Company A comes up with an idea that will yield huge sums of money for five years and then drive the company to bankruptcy. They implement the idea, obfuscating the downside, and soon the company is rolling in cash. Investors line up to give them money, magazines laud them, and other companies begin imitating them.
Not so Company B. Company B believes in long-term thinking, and can see this idea for the sham it is. They persue a quiet, sound strategy, even when their investors begin pulling money out to invest in A.
We would like to think that in the end, Company B will be left standing and reap them benefits of their foresight. But there is a fundamental problem of time-scales here: by the time A folds, B may already be out of business, due to lack of interest from investors. In theoretical terms, there is a fundamental problem when the evolutionary process proceeds faster than the unfolding of negative consequences. In these situations, good ideas never have a chance to be rewarded, evolutionarily speaking.
One might argue that investors, not to mention government regulators and ratings agencies, should have forseen the flaw in A’s plan. But this highlights a second limitation of the evolutionary process: it favors complexity. Simple bad ideas can be detected by intelligent agents, but complex ones have a chance to really stick. If Company A’s idea was so complicated that no one aside from a few physicists could figure it out, investors and regulators could easily be fooled.
It’s not clear to me how to patch these flaws in the evolutionary system. Increased transparency and oversight will help, but unless we can somehow cap the complexity of financial instruments (difficult) or slow down the evolutionary process (impossible), I’m not sure how we’ll avoid similar crashes in the future.