An Inquiry into the Nature and Causes of the Collective Hangover of Tax Payers, When Wall Street Gets Drunk

14 11 2009

Abstract

The perennial debate about unbridled free markets with or without safety nets, stifling socialism with its inefficient central planning and control, individualism, collectivism, life, liberty and pursuit of happiness is rekindled with the recent near-catastrophic economic downturn caused by the Wall Street innovators, the high priests of global commerce, who broker the trade of global goods and services.  While the classical theories of economics have served us well during the industrial and post-industrial periods, the advent of information technology has introduced a new wrinkle into the economic equation, namely the real-time nature of global communication, commerce and collaboration at the speed of light transcending space-time boundaries.  For example, recently, if you were an investor, you would have noticed the impact of a falling value of the US dollar, in the immediate rise of stock prices (within milliseconds) even when half of the world was still sleeping.  The stock prices of billion dollar companies that have been very successful in business for decades wildly fluctuate hour to hour based on some pronouncements of few self-appointed pundits and analysts on daily business networks.  These pundits attribute instantaneous cause and effect between an innocuous comment by the president or a surprise international event and gold price or oil futures. 

In this paper we study the impact of global communication, collaboration and commerce at the speed of light on the global economy and explain the reason why when Wall Street gets drunk, the Tax Payers get a collective hangover.  

Using the Gaussian superposition principle, Shannon-Nyquist information theory and an inquiry into the impact of ‘global communication, collaboration and commerce at the speed of light’, we demonstrate that the invisible hand that shapes the ebb and flow of commerce in a free market can be manipulated by a few and cause economic instabilities.  A balance between individualism and collectivism through a well-governed society is required to avoid harm to a larger population who depend on the economy for their livelihood and retirement without a safety net, and are unwittingly affected by the follies of a privileged few. 

Introduction

“Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society which we actually live, with the result that its teaching is misleading and disastrous if we try to apply it to the facts of experience.”                                                                  John Maynard Keynes 

“The facts of experience” are quite different today, much more so than in the days of Keynes, when he proposed the general theory of employment, interest and money [1] while pointing out how different the characteristics were during his day compared to the assumptions made by the classical economists such as Adam Smith.  

Recently, Senator Jay Rockefeller started his senate hearing on “distracted driving”, with a statement that at any moment, eleven percent of the population in the United States is holding an electronic device and is distracted from the task at hand, such as driving while communicating at the speed of light, using voice, text or video.  

Then there is the embarrassing moment, where President George Bush found himself caught on a video [2] speaking about how big business had failed in managing the sub-prime mortgage crisis and caused a systemic danger to the economy, which resulted in a major recession: “There’s no question about it. Wall Street got drunk –that is one of the reasons I asked you to turn off the TV cameras — it got drunk and now it’s got a hangover. The question is how long will it (take to) sober up and not try to do all these fancy financial instruments.” 

More recently, the social networking websites played a major role during the Iranian election and the resulting aftermath [3].  “Twitter is, far and away, the best social media tool for second-by-second information on what’s happening in Iran. People on the ground and across the globe are chatting about every breaking update, every news item, and every story they find….   Everybody’s favorite social video site YouTube has been a central distribution medium for the Iran riots. Iranians have been posting videos nonstop of what’s happening on the ground. This really is the best way to see what’s happening without any filters…… One blog stands out for its Iran coverage: Revolutionary Road has been bringing constant updates on the Iran Riots from the front lines. We rely on citizens like these to get us news from the ground.…… The social media photo site Flickr is brimming with some eye-popping and gut-wrenching imagery from the ground. Beatings, protests, military photos from the election…it’s all there, in full color.” 

All the three examples highlight the transformation that has been occurring over the last decade in how we have come to depend on global communications, collaboration, and commerce at the speed of light transcending both space and time boundaries.  While some claim that this has opened new opportunities for individuals to indulge in life, liberty and the pursuit of happiness, others argue that the opportunities are limited to only the top one percent of the population and others are left behind struggling to make ends meet.  

The perennial debate about unbridled free-market forces on the one extreme and the stifling collectivism with planned economies on the other extreme is raging again with pundits positing the virtues and the vices of both approaches, the chatter now being escalated in its volume and intensity through 24×7, real-time communication over voice, data video channels at the speed of light.  In this paper, we reexamine the concepts of individualism, collectivism, animal spirits and group harmony to understand the economic realities when individuals and groups engage together as a network of connected individuals, in improving life, liberty and pursuit of happiness.  The “network effect” has a profound influence on the outcome of the group transcending beyond the intent of each individual and creating the effect of the “invisible hand” described by Adam Smith in his classic work [4].  The result becomes even more dramatic when the network facilitates communication, collaboration and commerce at the speed of light. 

In this paper, we examine the impact of this real or perceived information leverage on the affairs of men and women and show why when one part of the economy gets drunk, it results in a collective global hangover.  In today’s economy where the access and use of knowledge provides a huge advantage (or disadvantage), individuals and groups can become unwitting victims, and pay for other’s follies if they do not actively measure, manage and optimize their own affairs leveraging communications, collaboration and commerce at the speed of light.  Information access at the speed of light has transformed the Wall Street to become real-time gambling casino where people trade the future of companies and commodities based on instantaneous knowledge.  Gambling like drinking can become a vice in short order if attention is not paid to its impact on others.  Social drinking is pleasurable and an occasional red wine may be good for the matters of heart, but excessive alcoholism becomes a social evil when it impairs judgment and causes harm to others.  

Even Adam Smith recognized the need for a well-governed society that guards itself against excesses. 

“The great multiplication of the productions of all the different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people. Every workman has a great quantity of his own work to dispose of beyond what he himself has occasion for; and every other workman being exactly in the same situation, he is enabled to exchange a great quantity of his own goods for a great quantity, or, what comes to the same thing, for the price of a great quantity of theirs. He supplies them abundantly with what they have occasion for, and they accommodate him as amply with what he has occasion for, and a general plenty diffuses itself through all the different ranks of the society.” 

Of the division of labour, Individualism, and Collectivism

“Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours; I am willing to give this for that. When an animal wants to obtain something either of a man or of another animal, it has no other means of persuasion but to gain the favour of those whose service it requires. A puppy fawns upon its dam, and a spaniel endeavours by a thousand attractions to engage the attention of its master who is at dinner, when it wants to be fed by him.                                                                              Adam Smith 

sociobiology not withstanding, with his almost poetic descriptions, the master [4] explained how an individual pursues economic self-interests intending only his/her own gain and as an unintended consequence, he/she behaves as if led by an invisible hand to promote an end which was no part of his/her intention.  Smith clearly articulates the role of specialization, separation of concerns through division of labor, the role of contractual obligation, the role of productivity and the influence of the free market’s invisible hand shaping the ebb and flow of commerce. 

The opening web page of the Adam Smith Institute [5] succinctly summarizes the importance of the work and makes it all available on-line. 

“This remarkable book was published in 1776, at a time when the power of free trade and competition as stimulants to innovation and progress was scarcely understood. Governments granted monopolies and gave subsidies to protect their own merchants, farmers and manufacturers against ‘unfair’ competition. The guilds operated stern local cartels: artisans of one town were prevented from travelling to another to find work. Local and national laws forbade the use of new, labour-saving machinery.  

 And, not surprisingly to us today, poverty was accepted as the common, natural, and inevitable lot of most people.  

 Adam Smith railed against this restrictive, regulated, ‘mercantilist’ system, and showed convincingly how the principles of free trade, competition, and choice would spur economic development, reduce poverty, and precipitate the social and moral improvement of humankind. To illustrate his concepts, he scoured the world for examples that remain just as vivid today: from the diamond mines of Golconda to the price of Chinese silver in Peru; from the fisheries of Holland to the plight of Irish prostitutes in London. And so persuasive were his arguments that they not only provided the world with a new understanding of the wealth-creating process; they laid the intellectual foundation for the great era of free trade and economic expansion that dominated the Nineteenth Century.  

 The Wealth of Nations changed our understanding of the economic world just as Newton’s Principia changed our understanding of the physical world and Darwin’s Origin of Species.” 

Time changes everything and new theories challenge or augment even the best of them.  Just as Einstein’s theory superseded Newtonian mechanics, with the observation that the speed of light is a constant, John Maynard Keynes added the concept of animal spirits that transcend the rational behavior of individuals and harness the uncertainty or ambiguity through creative speculation [1].  

While Adam Smith explained, why people employ each other when they pursue commerce, albeit with pure self-interest, Keynes explained why, in a closed system, there is always some amount of unemployment during a period of economic equilibrium.  He introduced the concepts of aggregate output and the demand driven economic equilibrium where unemployment is possible and departures from equilibrium caused by various factors including speculation based on “animal spirits” [1]. 

“It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.” 

The master goes on and makes the following observations that are so appropriate in the context of today’s collective hangover and rising unemployment. 

“There are, moreover, certain important factors which somewhat mitigate in practice the effects of our ignorance of the future. Owing to the operation of compound interest combined with the likelihood of obsolescence with the passage of time, there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future. In the case of the most important class of very long-term investments, namely buildings, the risk can be frequently transferred from the investor to the occupier, or at least shared between them, by means of long-term contracts, the risk being outweighed in the mind of the occupier by the advantages of continuity and security of tenure. In the case of another important class of long-term investments, namely public utilities, a substantial proportion of the prospective yield is practically guaranteed by monopoly privileges coupled with the right to charge such rates as will provide a certain stipulated margin. Finally there is a growing class of investments entered upon by, or at the risk of, public authorities, which are frankly influenced in making the investment by a general presumption of there being prospective social advantages from the investment, whatever its commercial yield may prove to be within a wide range, and without seeking to be satisfied that the mathematical expectation of the yield is at least equal to the current rate of interest, — though the rate which the public authority has to pay may still play a decisive part in determining the scale of investment operations which it can afford. 

Thus after giving full weight to the importance of the influence of short-period changes in the state of long-term expectation as distinct from changes in the rate of interest, we are still entitled to return to the latter as exercising, at any rate, in normal circumstances, a great, though not a decisive, influence on the rate of investment. Only experience, however, can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment. 

For my own part, I am now somewhat skeptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organizing investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.” 

More recently, the book “Animal Spirits” [6] by the Nobel Laureate George Akerlof and Robert Schiller takes the discussion to the next level.   They discuss the impact of human factors such as confidence, fairness, corruption & antisocial behavior, money illusion (caused by fear of inflation or deflation) and the human need for a sense of reality through creating narratives or stories, on the deviations from equilibrium and shape the destinies of groups. 

The long and short of the economic story is that: 

  1. When individuals act with self-interest in a group, it creates an economic equilibrium where the individual behavior is guided by an “invisible hand” of market forces shaping the ebb and flow of commerce resulting in specialization, separation of concerns, scalable network of management structures etc.
  2. One type of deviation from equilibrium occurs when external conditions change demand, technological changes cause productivity improvements or affect supply chain of resources.  Classical theory of economics explains and estimates these deviations.
  3. Another type of deviation from equilibrium occurs when animal spirits prevail and take risk to harness the ignorance and uncertainty of the future.  This often can change the equilibrium state in a profound manner.

Human factors such as confidence, fairness, corruption etc., impact the equilibrium.  While they may be tolerable in small doses, the multiplier effect depending on the size and scope can cause instabilities. 

entropy

Figure 1: Entropy minima and economic equilibria

Figure 1 shows the different levels of equilibrium and corresponding levels of unemployment and how the levels of equilibrium are attained by the impact of animal spirits or instabilities caused by human factors.  It is important to note that the productivity improvements in an equilibrium state are obtained through Kaizen or continuous incremental improvements and paradigm shifts and orders of magnitude impact are often obtained through animal spirits taking risk to cause the chaos required to cross the entropy barrier to next lower minimum.  The instabilities caused by human factors often lead to higher level of equilibrium (hopefully last only for a short period before being rescued by animal spirits). 

In the next section, we discuss a major disruption that has changed the way affairs of men and women are conducted and its impact on the economic equilibrium. 

of the Communication, Collaboration, and Commerce at the Speed of Light

In 1965, Intel co-founder, Gordon Moore published an article in Electronics magazine that was the source for what became known as Moore’s Law, which says that computers double in capabilities every 18 months.  During the four decades following the statement, we have seen a radical transformation in the way people are connected with each other and communicate.  This was made possible by the evolution of telecommunications infrastructure and the voice network services management platforms that allowed dynamic and real time allocation of resources to optimize voice connection and messaging infrastructure. 

Thirteen years later, in 1998, Nielsen observed that the Internet bandwidth is growing at 50% annual growth rate.  A decade later, we are seeing a radical transformation in the way computers communicate with each other.      The resulting Internet data connection and data services management platforms have facilitated a new level of human interaction through information sharing. 

The result of bandwidth inversion (the network bandwidth is large enough that the information access is limited by only the speed of light) is an information infrastructure that connects global human networks and facilitates real-time communication, collaboration and commerce.  Since the beginning of time, bandwidth had a major influence in how humans organized themselves in groups (or human networks) to evolve and adopt ways to respond to changes in their environment.   According to Vancho Cirovski, [6], the effectiveness of the human network depends on the connections, communication and mastery (or specialization) of the individual human agent.  Better the quality of mastery of the individual (forming the node in a human network), the quality of connection and communication, the higher the effectiveness.  Humans have created organizational frameworks through evolution.  According to Malone [7], organization consists of connected “agents” accomplishing results that are better than if they were not connected.  An organization establishes goals, segments the goals into separate activities to be performed by different agents, and connects different agents and activities to accomplish the overall goals.  Scalability is accomplished through hierarchical segmentation of activities and specialization.  

There is always a balance between the cost of coordination of the agents and economies of scale obtained from increasing the network size, which defines the nature of the connected network.  Efficiency of the organization is achieved through specialization and segmentation.  On the other hand, agility of an organization depends on how fast the organization can respond to changes required to accomplish the goals by reconfiguring the network.  Dynamic reconfiguration is accomplished using signaling abstractions such as addressing, alerting, supervision and mediation.  

Connection management is achieved through effective communications framework.  Over time, human networks have evolved various communications schemes and signaling provides the fundamental framework to configure and reconfigure networks to provide the agility.  The bandwidth of communication determines the organizational structures.  Groups or subgroups requiring a high degree of communication, band together and optimize the bandwidth available.  If the bandwidth of communication is large enough, the groups tend to get distributed to optimize the resources available.  

Of the General theory of Economics, The Gaussian Superposition and Information Content

When individuals form into groups, inevitably the statistics, probabilities and the laws of large numbers come to play whether we like it or not.  In probability theory, the Gaussian (also called Normal) distribution plays a central role by representing a stable or equilibrium distribution toward which all other distributions gravitate under a wide variety of conditions such as large numbers, convolutions and stochastic processes.  Figure 2 shows [8], the Gaussian distribution. 

gauss

Figure 2: Gaussian Distribution

The figure shows two distributions using the formula 

 equation 

where µ is called the mean and σ is called the standard deviation.  

The uniqueness of the Gaussian (also called normal) distribution, ubiquity of its use and its elegance in which just two parameters provide the information content of a series of observation with the principle of maximizing entropy and the history of its discovery and evolution are well documented and provide a fascinating journey into the annals of mathematics [8]. 

Consequently, if you have a collection of individuals engaged in an activity together, particular skill level or knowledge of the individuals will be spread around a value given by the mean, and the standard deviation gives a measure of how far the skill varies from the mean.  About 68.3% of the people fall within 1 standard deviation and 95.4% fall within 2 standard deviations and 99.7% fall within 3 standard deviations.  The mean and standard deviation characterize a particular group. 

In a society that values individualism culture, both the latency of information access and the latency tolerance of customers receiving the goods and services were limited by physical proximity and transportation network speeds.  In a world that is globally connected at the speed of light, the divergence of the latency between information access and the latency of fulfillment of contractual obligations introduces a new element and those leveraging the information can manipulate the invisible hand to disadvantage others who do not have access to the same information.  The impact becomes more dramatic when information is influencing investment decisions at the velocity of light.  

We represent this for a homogeneous group (who can be parameterized by a single mean and a single standard deviation) in figure 3. 

homogeneous

Figure 3: Homogeneous distribution of skills and knowledge leverage distribution

In figure 3, individual skill is represented by a gaussian distribution.  The knowledge leverage is represented by a another Gaussian distribution with the same mean and standard deviation representing the impact of access to knowledge in a global commerce at speed of light.  Slight variations in knowledge leverage and distribution of skill lead to great variation in the ratio of losers to winners.  Figure 4 shows these variations. 

reduction

Figure 4: Impact of Variation of mean on winners & losers

The complexity becomes even greater if you consider superposition of different groups with different means and standard deviations in a global network where only a few people are impacting the lives of many through real-time information management. 

heterogeneous

Figure 5: Impact of Heterogeneous groups on winners & losers

The information theory of Shannon postulates that the noise in a series of observations increases when the sampling frequency becomes higher than the frequencies present in the signal.  Obviously, if commerce transactions in real world are conducted at frequencies lower than the sampling frequency at which investors make decisions and change them, then small variations caused by daily events are exaggerated and can cause instabilities by increasing the entropy.  The impact of knowledge mastery and access to information depends on the mean and width of the distribution function and as this function becomes narrower making the system depend only on a relative few, the probability of causing instability becomes larger. 

Of the Real-Time Universe, Noise, Entropy, Life, liberty and persuit of happiness

If the purpose of life is to pursue happiness in an environment that supports individual freedom and choice, then individuals have to develop the skills to monitor, manage and optimize the resources that are available to them to pursue their goals.  The availability of resources depends on external circumstances some of which are under their control and some that are not, such as the acts of nature.  It also depends on the availability and the abundance of resources and the competition from others also pursuing their own happiness.  The economic system of Adam Smith as we have seen creates an equilibrium where individuals form into groups with similar goals and collectively pursue happiness together to optimize the resources available to the group. 

Humans have developed a network model of distributed computing where individuals specialize in developing skills to collect information, analyze and control the environment to accomplish the goals of the group.  The law of large numbers postulates that in any group, there is a normal distribution of skills and the groups distinguish each other by the spread and mean of these distributions.  

In an environment where the information access is slower than the need with which one has to interact with the environment of necessity, risk management is implemented to cover the ignorance or higher entropy involved.  In the case where information access is faster than the time scales in which the external environment responds, it can lead to a situation in which lot of noise can be created in manipulating the system without waiting to see the effect.  Current technological advances have created a situation where information access and control of economic systems are limited only by the speed of light.  That has created two important effects: 

  1. High level of noise in the economic system that masks real signals that are relevant to advancing the cause of the whole group and
  2. Instabilities that can occur with feedback that can cause global headaches when individuals make manipulative moves and the invisible hand does not have the time to respond before the instability causes the damage

In addition, the skill level required to process the information and act intelligently is limited to a few, and the system becomes vulnerable to the individual frailness.   

Unless, systemic process checks and balances are introduced to dampen the fluctuations caused by the privileged few, many will be affected unwittingly with no fault of their own. 

Adam Smith’s “well-governed society” becomes a true requirement for individuals to enjoy life, liberty and pursuit of happiness in a society where communications, collaboration and commerce are always at the speed of light. 

Conclusion

In this paper, we reviewed theories of how individuals form into groups driven by self-interest to better their own lot and in the process give rise to an invisible hand that shapes the group behavior, which in turn benefits everyone in ways not intended by the individuals.  The group behavior led by the invisible hand leads to an economic equilibrium with stable employment levels.  The deviations from equilibrium can occur when external changes cause perturbations to supply and demand or technological changes cause improvements to productivity.  Classical economic theory explains the cause and effect of small deviations from equilibrium.  

However, external forces causing large deviations from equilibrium that in turn can lead to instabilities, could manipulate the invisible hand.  Two kinds of instabilities are discussed.  Keynes discusses the positive kind, where Animal Spirits (that transcend the rational behavior of individuals and harness the uncertainty or ambiguity through creative speculation) can create such instabilities, which can eventually lead to new equilibrium points with different levels of unemployment.  

Human factors such as confidence (or lack thereof), fairness or unfairness, corruption etc., also impact the economic equilibrium.  While they may be tolerable in small doses, the multiplier effect depending on their size and extent can cause instabilities.  These instabilities cause disruption and usually end up in higher level of unemployment and economic down turn.  The invisible hand may attempt in the long run to correct the situation but in the short run, there is a possibility for irreversible transitions. Even Adam Smith has acknowledged the need for a well-governed society to create the right conditions for maintaining equilibrium economics. 

More recently, the technological advances that have made it possible for groups to engage globally in communication, collaboration and commerce at the speed of light, have introduced a new element that influences the economic equilibrium profoundly.  They change the odds of individual success, which becomes very much dependent on access to knowledge and the skill to act on it at the speed of light.  This has concentrated the power to influence the free market in the hands of a few who can manipulate the invisible hand, resulting in the benefit of a few at the expense of many.  The recent hangover that is felt by the tax payers world-wide when a few Wall Street bankers got drunk with their clever schemes is a clear example of the inequities that can cause economic instabilities. Narrower the population that leverages knowledge at the speed of light, greater is the risk of causing irreversible instabilities.   

We have demonstrated using Gaussian superposition of skill level of individual groups, how a few with access to information can win in the economic game at the expense of many who lose.  In addition, the Shannon Nyquist theorem shows that the real-time analysis of various economic entities that change much slower in time causes lot of noise and does not add to the stability of the economic equilibrium.  The stock prices of enterprises are burdened with a short term noise fluctuations that are independent of the actual long term performance and are solely created by the speculation.  In a well-governed society, groups will impose self-will to provide incentives to reduce the noise and restore equilibrium.  A well-governed society also will decide whether the Wall Street is a gambling casino and is treated as such with appropriate regulation that befits a casino or a long term investment vehicle that creates economic equilibrium and facilitates long term growth with appropriate risk/reward incentives.  A well-governed society also allows animal spirits to develop innovative paths to new states of lower entropy and the society at large is protected from human frail qualities such as excessive corruption, unfairness etc. 

[1] Keynes, John Maynard , “The General Theory of Employment, Interest and Money”, Atlantic Publishers and Distributors, New Delhi, India 2006 (First published in 1936) 

[2] Read more at: http://www.huffingtonpost.com/greg-mitchell/banned-bush-video-surface_b_114363.html, and see the video at http://www.disclose.tv/action/viewvideo/6169/Bush_in_leaked_video__Wall_Street_got_drunk_/ 

 [3]  http://mashable.com/2009/06/14/new-media-iran/ 

 [4]  Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations. Edwin Cannan, ed. 1904. Library of Economics and Liberty. 2 November 2009. . 

 [5]  http://www.adamsmith.org/smith/won-intro.htm, Preface By Dr. Eammon Butler, DIirector Of The Adam Smith Institute, London, 2001 

 [6]  http://www.orgnet.com/MCO.html “Managing the Connected Organization” by Valdis E. Krebs 

 [7]  Thomas W. Malone, “Organizing information systems: Parallels between human organizations and computer systems”, Cognition, Computing and Cooperation, edited by Scott P. Robertson, Wayne Zachary, John B Black, Greenwood Publishing Group, January, 1990 

 [8] http://en.wikipedia.org/wiki/Normal_distribution