One of the salient characteristics of the modern economy is that an amazingly complex web of interactions can develop among agents who barely, if at all, know each other, to produce results that give the impression of a strong and conscious coordination (an “intelligent design”). This is, of course, in essence nothing but Adam Smith’s invisible hand in action, but the complexity of modern-day financial arrangements would have been unthinkable when The Wealth of Nations was written. Accepting that “no one is in charge” but that an intricate network of transactions will, most of the time, work very well remains to this day difficult to accept from an intuitive point of view. “Please understand that we are keen to move toward a market economy,” a senior Soviet official whose responsibility had been to provide bread to the population of Saint Petersburg in its communist days told economist Paul Seabright,∗“but we need to understand the fundamental details of how such a system works. Tell me, for example, who is in charge of the supply of bread to the population of London.” In the industrialized Western world we may have forgotten how astonishing the reply is (“nobody is in charge”), but this does not make it any less so. In a similar vein, looking at a small portion of butter offered as part of an in-flight meal, Thomas Schelling (rhetorically) asks:
How do all the cows know how much milk is needed to make the butter and the cheese and the ice cream that people will buy at a price that covers the cost of maintaining and milking the cow and getting each little piece of butter wrapped in aluminum foil with the airlines’s insignia printed on it?∗
Of all these complex, resilient, self-organizing systems, the financial industry is probably one of the most astonishing. Nobody was “in charge” to ensure that when the couple from Long Island walked into their local bank branch they would get a competitive quote for their mortgage in hours; nobody was in charge to make sure that the depositor who provided the funds needed by the couple to purchase their house would be forthcoming just at the right moment; nobody was in charge when the same depositor changed his mind a week later and withdrew the money he had deposited; nobody was in charge to ensure that a buyer would be willing to part with his money within hours, or minutes, of the security from the pool of mortgages being created and offered on the market; and when, thousands of miles away, a Bank of China official decided to invest some of the Chinese trade surplus in the purchase of the same security, nobody had communicated his intentions and nobody had arranged for a market maker to buy the security itself from the primary investor and hold it in his inventory. Nobody is in charge and yet, most of the time, all of these transactions, and many more, flow without any problems.
There, however, in that innocent “most of the time,” is the rub. The financial system is robust, by virtue of literally hundreds of self-organizing corrective mechanisms, but it is not infinitely robust. This is not surprising because the cornerstone institution of the financial system, the bank itself, is precariously perched on the border of stability: just because nobody is in charge, every day a bank owes its existence to the law of large numbers. How does this happen? The most fundamental activity of a bank is the so-called “maturity transformation”: accepting money from depositors who may want it back tomorrow, and lending the “same money” to borrowers who may want to hold on to it for thirty years. This is all well and good unless all of the depositors simultaneously want their money back. In normal conditions, of course, it is virtually impossible for this to happen, and the statistical balance between random withdrawals from depositors and equally random repayments from borrowers requires a surprisingly small safety buffer of “liquid cash.” And, by the way, many other arrangements in our nobody-is-in-charge industrialized world rely on a similar (apparently fragile and precarious) statistical balance: from the provision of food to the distribution of electricity, the use of roads, telephone lines, petrol stations, etc. As long as all the users make their decisions close-to-independently, only a relatively small safety margin (of spare electricity, spare phone line capacity, petrol in filling stations, food on supermarket shelves, etc.) has to be kept.
-Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently
Riccardo Rebonato
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