The BCG Henderson Institute and the Institute for New Economic Thinking recently had the pleasure of hosting a seminar on the topic of financial systems as complex adaptive systems and what we can learn from biology about how to regulate them effectively. An assembled audience of CEOs, economists and academics had the privilege of hearing from three thought leaders on the topic: Simon Levin of Princeton University, Andrew Lo of MIT and Richard Bookstaber of University of California.
Simon kicked off the discussion by sharing the close similarities between ecological and financial systems. Both exhibit non-linearities, multiple stable states, contagion, hysteresis and synchrony. It is no accident that economics and ecology share a common etymology. Both can exhibit resilience but also fragility if pushed beyond their limits — an idea which Simon explores in his book Fragile Dominion and his prescient article “Ecology for Bankers” (2008), which foresaw the financial collapse. Effective regulation of complex systems depends on the balance of positive and negative feedback loops, which can be upset by factors that work only on one side of this equation, like high speed trading. Effectively, financial innovation outpaced the ability of static regulatory mechanisms to deal with it. Simon made the case for new thinking on regulation: While approaches based on rigidity may work in the short term and under stable conditions, regulation based on flexibility and adaptation is likely to be more effective in the long term and under unpredictable conditions.
Andrew translated many of these biological insights into the economic domain, drawing upon ideas from his recent book, Adaptive Markets (2017). He contrasted the efficient market hypothesis, upon which classical financial theory is based, with the adaptive markets hypothesis. The latter assumes that individuals act in their self-interest, they make mistakes, they learn, competition drives innovation and evolution determines market dynamics. Andrew showed, using the vivid example of automotive safety, how classical regulatory approaches can be systematically self-defeating. He made the case for a new ecological perspective toward both investing and regulation.
Richard synthesized and reconciled the biological and economic perspectives, drawing from his own recent book, The End of Theory (2017). He showed how agent-based modeling provides an effective approach for modeling the non-linear, emergent behaviors of such systems. He wrapped up the session by exploring the importance of diversity, coarse heuristics and evolvability in regulating and ensuring the stability and longevity of complex systems. Coarse heuristics are those which are simple and effective under a wide range of conditions. Conversely, he explained how conventional regulation can deplete diversity, create complexity and actually reduce the ability to adapt to unforeseen circumstances.
Collectively, the three speakers laid out a clear alternative to traditional ways of thinking about how economic systems work and how they can be effectively regulated.