Way back, many years ago in college, I attended a local nerd event Penguicon, a sci-fi/Linux/gaming mash-up convention*. By far the most interesting speaker was the science guest of honor, Jack Cohen, a British complex systems Biologist who has done a lot of consulting work with science-fiction and fantasy authors (e.g. The Science of Discworld). In one of Cohen’s talks, he recalled a time when a journalist called him and asked him to explain two seemingly unrelated events: an outbreak of infections from bad milk and a recent railway collision. He was puzzled at first but then responded, “Efficiency is the opposite of robustness.” This idea is probably not so novel to most people reading this blog, but to young me it sounded very profound, and I often think back to Cohen’s phrasing of the trade-offs between the two.
For example, this morning I read two articles from the Economist about the financial crisis and its fall-out: “All you need is cash” and “To spend or not to spend”. The first story reanalyzes pre-crisis debates on the importance of leverage, and critiques of overly-thrifty corporations which kept large reserves of cash on hand:
Ever since the 1980s the fashion had been to make companies as lean as possible, outsourcing all but your core competencies, expanding your just-in-time supplier system around the globe, loading up with debt to “leverage” your balance-sheet. Old-style defensive conglomerates, such as Arnold Weinstock’s General Electric Company, were dismantled. Companies that hoarded cash—even ones as good as Toyota and Microsoft—were viewed with suspicion.
The financial crisis, and particularly the sudden disappearance of liquidity in the commercial paper market, led to a lot of rethinking about the importance of cash-on-hand. In general though, the problem has the form of an efficiency vs. robustness trade-off. High leverage ratios make sense in normal times, and until something goes wrong will produce higher returns. But that seemingly efficient distribution of resources is not robust to shocks of any size. And when everyone is similarly leveraged, small shocks become large ones.
At the other end of the economy, “To spend or not to spend” argues that the US federal government needs to start spending like mad. Wouldn’t it be nice if the government had some sort of reserve of money, saved up from good times? But in good times, saving was seen as inefficient – it would have dampened growth. Consumers and the government spent, spent, spent. Now we think if only we’d tamped down that rampant spending, and not propped up the markets with a housing bubble to replace a dot.com bubble, this crisis could have been averted. Classic Keynesianism sounds pretty good right now, even if it sounds like a fire alarm.
Ok, that didn’t tie together quite as neatly as I might have liked. So it goes. Here’s the provocative close though: Following Cohen, does an “efficient market hypothesis” have a “fragile market corollary”?