Read an Excerpt simplexity
Why Simple Things Become Complex (And How Complex Things Can Be Made Simple)
By Jeffrey Kluger
Copyright © 2008
All right reserved.
Chapter One Why is the stock market so hard to predict?
Confused by Everyone Else
WHAT MIGHT BE THE THREE MOST expensive words ever spoken were uttered on October 15, 1987. Few people suspected the impact of the words at the time, their seeming blandness entirely belying their power. But the words weren't chosen to be bland. In the coded vocabulary of the diplomatic world, they were actually chosen for their bite. It was just that nobody expected they'd bite so hard.
It was then-Secretary of the Treasury James Baker III who did the speaking that day, not long after returning to Washington from a meeting in Bonn with his West German counterpart. Baker had good reason to be in that particular country meeting with that particular minister. The German economy, which had long been the strongman of Europe, had pulled a charley horse of late, with the mark stumbling significantly and the ability of the German people to buy pricey American goods falling with it. If those goods stayed on the shelves when the U.S. economy itself was already struggling under the twin loads of growing trade and budget deficits, the strain could be just enough to trigger a recession. This did not please Washington, and Baker had gone to Bonn in part to carry the message that he-to say nothing of President Reagan-would appreciate it if the Germans would lower their interest rates and juice the mark a bit, so that their consumers' buying power would rise commensurately. The German finance minister made it clear that he would lower his interest rates when he wanted to, and this was not that time. In fact, he might even raise them a tick, as he had on other occasions recently.
Baker was unhappy with this response-"not particularly pleased" was the three-word way he described it-and hinted darkly that if German rates did not drop, he might have no choice but to free up the dollar a little and allow it to drift against the mark. This might level things out in the short term, but it would increase the risk that the cold both economies had caught of late would turn into a full-blown flu. It was a good threat and a well-phrased one, precisely the kind of diplomatic sempahoring the situation called for. It no doubt did the job in Bonn, but more than just the Germans got nervous.
By the next morning, Friday, October 16, word of Baker's warning seeped through the investment community. When it did, investors decided they wanted no part of the looming catfight over currency. Markets had spent the Reagan era on a near-seven-year climb, and now seemed like a good time to cash out some winnings and head for the exits. That day, the Dow Jones average fell 108.36 points, a 4 percent loss that was a serious blow even for an index that had opened the day above 2,355. The plunge suggested only worse things to come, and a Friday was either a very good time or a very bad time for the first upheaval to have happened-good because traders would have the weekend to collect themselves and lower the temperature before the market opened again on Monday; bad because they might instead use that two-day respite as a time to worry and stew. On Monday, October 19, at 9:30 A.M., it quickly became clear which course they had chosen.
In the first thirty minutes of trading on that nervous morning, 50 million shares were sold, knocking fully sixty-seven points off the Dow, or 2.8 percent of its value. This was exactly the kind of early bleeding analysts had spent the weekend dreading, and at the news that it had begun, more investors-the majority of them with nothing more than small personal portfolios-began to unload their holdings as well. Within another half hour, a total of 101 points had been slashed from the Dow, 4.2 percent of its value at the opening bell, and 140 million shares had been sloughed off-or about the typical trading volume for an entire day. By eleven o'clock yet another hundred points were shed and tens of millions more shares unloaded, and that didn't tell the entire story. The Dow ticker, unable to process the flood of sales, was running nearly twenty minutes behind. There were surely untold millions of shucked shares hidden in that third of an hour.
Now the global markets' nightmare scenario-a blind stampede-began. By noon, the market losses totaled 240 points, a 10 percent loss in just a matter of hours. Spectators began to jam the gallery of the New York Stock Exchange, watching both the bloodletting below and the news from overseas streaming in on the big boards. Around the world, those boards showed, the markets of Europe, the Pacific, and particularly Japan were also in chaos, losing value almost as fast as the American one. What's more, by now, computers had joined the frenzy the investors had started, with programmed trades designed to dump dying stocks when their prices fell below certain levels doing just that-behaving no more rationally than the panic-prone people who had written the hair-trigger software. The more the computers tossed their holdings overboard, the more the individual investors followed suit, making it likelier that the machines would jettison still more.
By 2:00 P.M., the Dow free-fell through the two-thousand mark, and with that psychological floor no longer holding prices up, the plunge accelerated even further. By 2:15 the loss stood at three hundred points, or 12.7 percent off the market's opening value. Before 3:00 it was at four hundred, a sickening 17 percent loss. With the market ticker now running a full 111 minutes behind-as good as if it weren't running at all-no one doubted that the crash was reaching some kind of terminal velocity. The only thing that would stop it would be the hard pavement of the end of the trading day, which at long last arrived at 4:00. When the closing hammer finally fell, the Dow was in a shambles, having lost a record 508 points-or 23 percent of its value-on an unprecedented 604 million traded shares. (At the thirteen thousand mark the Dow broke for the first time in early 2007, that would be the equivalent of a one-day loss of just under three thousand points.) In just that six and a half hours, half a trillion dollars in American wealth had been incinerated. Overseas, the Tokyo exchange shed 57 trillion yen, or 400 billion dollars; the London market lost 94 billion pounds, or 140 billion dollars. The French, German, Canadian, Australian, and Mexican markets all lost between 9 and 30 percent of their value. Four days earlier, the American treasury secretary had spoken, and at least partly in response to his handful of words, the world's financial markets had set themselves on fire.
Picking through the wreckage in the days that followed, analysts could only nod at the irrational-and predictable-mess that investors had made of their own wealth. Even with the growing deficits and the other market stresses-even with Baker's coolly lethal comment-nothing smart or sensible had taken place that day. But smart and sensible forces had not been at work. Market forces had been. And when it comes to simple, there's little to compare to those.
Never mind what you think about the exquisitely complex organism that is the world's financial markets. Never mind the hundreds of millions of thoughtful investors and their billions of well-considered trades. For every market analyst who sees traders as the informed and educated people they surely can be, there are scientists who see them another way entirely: as atoms in a box, billiard balls on a table, unthinking actors who obey not so much the laws of economics as the laws of physics. The things that result from those actions may be undeniably extraordinary-the creation or destruction of trillions of dollars of wealth in a matter of hours-but down at the fine-grained level at which the transactions are made, the players themselves can be remarkably simple things.
Investors react not so much to variables that are in their interests, but, oddly, to those that are in everyone else's interests. When the tide of the market shifts, most of us shift with it; when it flows back the other way, we do the same. We like to think we're informed by trends, but often as not, we're simply fooled by them-snookered by what everyone else is doing into concluding that we ought to do the same.
"Economic models always begin with the assumption of perfect rationality, of a universe of logical people all doing what they can to master their utility," says economist and ecologist J. Doyne Farmer, a former fellow at Los Alamos National Laboratories and now a resident faculty member at the Santa Fe Institute (SFI) in New Mexico, a think tank and research center devoted to the study of complexity. "Physicists studying economics begin with the assumption that people can't think."
"The term we use is zero-intelligence investors," says John Miller, an economist at Carnegie Mellon University specializing in complex adaptive social systems, and another member of the SFI faculty. "It's not a term that flatters the investors, but it does go a long way to describing what goes on."
If there's any group that has the credibility to make such provocative claims it's the Santa Fe Institute. And if there's anyone equipped to lead SFI's work, it's physicist Murray Gell-Mann.
Gell-Mann won a Nobel prize in 1969, the year he turned forty, for being the first investigator to sort out the confusion quantum theorists confronted when they studied the goings-on inside the atom. Since the late nineteenth century, physicists had been coming to the conclusion that the supposedly irreducible atom was not the last word on the structure of matter, and over time they identified a gnat-swarm of some one hundred subatomic particles tucked inside the atomic nucleus. Nobody, however, had been able to make any order of them all until Gell-Mann came along. He developed a sturdy new theory that sorted the particles into several different species of what are now known as quarks, all held together by forces he called gluons. The work gave instant clarity to an entire field and remains the core of particle theory into the twenty-first century.
Fifteen years after winning his Prize, Gell-Mann was approached by a small confederation of scientists wanting to know if he was interested in helping to found a nonprofit research center in the high desert of New Mexico to study the twin puzzles of what makes something simple and what makes it complex. Gell-Mann instantly took to the challenge, reckoning that having already brought discipline to the chaotic world of quarks, he might enjoy doing the same with the equally unruly swirl of specialties and subspecialties that makes up scientific theory. In 1984, the Santa Fe Institute was created, with Gell-Mann as its cofounder. Today, SFI is a hive of more than one hundred resident faculty members, postdoctorate fellows, visiting scholars, and other researchers, studying the internal clockwork of dozens of fields. Gell-Mann is still there, a philosopher father of sorts, and one who continues to give the group its gravitational center.
To the outsider, the precise function of SFI is not easy to grasp. The group's mission statement, printed in its annual reports and announced on its website, is itself hardly a model of simplicity, defining the Institute as a "multidisciplinary collaboration in pursuit of understanding the common themes that arise in natural, artificial, and social systems." To the extent that that's comprehensible at all, it sounds an awful lot like a think tank, where learned people just sit about and, well, think. And after a fashion, that's what the SFI scientists do. There is, however, more to it than that. In the cluster of the institute's interconnected buildings, or "pods" as the complexity scientists call them, all manner of things go on.
Over here is an ecosystems biologist looking at the elaborate food webs within a single small pond, with ninety-two different species eating or getting eaten in more than nine hundred different predator-and-prey combinations. Knock one organism out and you may not upset things too much; knock out a handful and the web starts to shake. Pick the one life form on which all of the others perch-the so-called keystone species-and the entire system can cascade. Think the computer models that explain all that don't have implications for human food sources, not to mention human social systems, economies, and even physical structures? Think again.
Elsewhere, someone is investigating the network of relationships in communities, office places, and even monkey troops, looking for the larger rules that can explain how information gets disseminated and ideas get exchanged, with implications for everything from politics to public health. Still elsewhere, physicists are studying the metabolism of animals, looking for the patterns that will reveal more about the life and death cycles not only of living things, but of institutions, cities, and even nations. All of these insights may reach their first audiences in obscure journals that nobody but other academics read. But all of them will then work their way through the knowledge web and find applications in the real world-much in the same way that the ideology that's driven the political right in the last twenty years was born in think tanks, as was much of what drove the political left in the decades before that.
Complexity, as both a scientific and social concept, is arguably more powerful than anything that comes out of a political institute. The first trick, however, is defining it. One of Gell-Mann's favorite ways of deciding whether something is simple or complex is to ask a decidedly unscientific question: How hard is it to describe the thing you're trying to understand? A rock? Easy. A car? Harder. The physics behind a supercollider or the structure of a Mozart opera? That'll take a while. "You start with minimum description length as your first inquiry," he says. "The shorter it is, the simpler the thing is likely to be. In most cases, you don't even have to take your language from scientific discourse. It can come from ordinary speech."
But description depends on context and context changes everything. Explain the protein coat of a newly discovered virus to a molecular biologist and you're in and out in a sentence or two. Explain it to someone utterly unfamiliar with virology and you'll be at it a lot longer. A football player or a soldier can similarly understand a new play or a battle plan with just a few chalk strokes; the virologist would be utterly flummoxed. "Imagine an anthropologist approaching a civilization with which he shares a common language, but which is naïve of any culture outside of its own," Gell-Mann says. "Now imagine trying to explain to that community a tax-managed mutual fund. What do you think the preamble to that explanation would be?"
Description length, however, has its limits. While it's a handy place to start thinking about complexity, it's naïve in its own way. The problem is that it begins with an assumption of a clean and consistent line, with simplicity and short descriptions at one end and complexity and long descriptions at the other. A clean line, however, doesn't really capture things as much as a somewhat messier are does.
Complexity scientists like to talk about the ideas of pure chaos and pure robustness-and both are exceedingly simple things. An empty room pumped full of air molecules may not be a particularly interesting place, but it is an extraordinarily active one, with the molecules swirling in all directions at once, dispersing chaotically to every possible crack and corner. On the other hand, a lump of carbon chilled to what scientists call absolute zero-or the point at which molecular motion is the slowest it can possibly be-is neither interesting nor active. The carbon is exceedingly static, or robust, as complexity researchers call it; the room is exceedingly chaotic. What neither of them is, however, is complex, offering only spinning disorder at one end and flash frozen order at the other.
Where you'd find real complexity would be somewhere between those two states, the point at which the molecules begin to climb from disorder, sorting themselves into something interesting and organized-a horse, a car, a communications satellite-but catching themselves before they descend down the other side of the complexity hill, sliding into something hard and lumpish and fixed. The more precisely the object can balance at the pinnacle of that arc, the more complex it is. "It's the region between order and disorder that gives you complexity," says Gell-Mann, "not the order and disorder at the ends."
Things, however, are not as straightforward as even that explanation suggests, since any one system is not necessarily composed of just one point on the arc. Often, many different points come into play and the question of complexity turns on which one you choose. A foot-long length of copper pipe might be nearly as static as the frozen carbon. But step back and take in the vast, arterial array of skyscraper plumbing of which it is just a part and things look a lot more complicated. Drill deep inside the copper and consider the subatomic universe within its atoms and the picture becomes more complicated still.
Excerpted from simplexity by Jeffrey Kluger
Copyright © 2008 by Jeffrey Kluger. Excerpted by permission.
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