The Evolutionary Algorithm & Complexity Economics

I just read this book - The Origins of Wealth by Eric Beinhocker. Thanks to Steve, CEO of an up and coming company, for bringing it to my attention. The books contents relate to my last article on genetic evolution and risk management albeit treating it in much more depth (and richness) as only a 450 page book can. I now feel vindicated in a sense that my ideas were not full tangent and there are more people seeing this as an entirely conceivable approach.

The book in itself  deals with complexity economics - a view that is in stark contrast with the static equilibrium views propounded in most contemporary economic texts and presents the economy as an dynamic evolutionary system that mirrors biological evolution. The key take away is - presentation of the economy as a combination of physical technologies (PT), social technologies (ST) and business plans (likened to biological DNA) that evolve to adapt to fitness funtions driven by participant choices. In this manner the economy evolves in a fashion very similar to biological evolution and the most efficient algorithm to evolve happens to be - as anyone can by now guess - the evolutionary algorithm driven by continuous micro risk taking. Apparently this happens to be the most efficient algorithm for searching roughly correlated  large design spaces (something the economic landscape subscribes to) for reaching the best possible fit.

Eric relates the economic system to a thermodynamic system. He deems wealth creation to be a consequence of  irreversible processes that reduce the local entropy of the economy.Wealth in essence is treated as a fit indicator and wealth creation is determined by how closely a business is able to match the fitness function. For the financial practiioners Eric's got some news - markets are not random {yes thats right NOT random). Financial markets are dynamic systems that are complex enough to give the appearance of randomness. This is evident in the applicability of power laws to return distributions and temporal variations that resemble punctuated equilibrium rather than covariance stationary processes. This part is identical to Nassim Taleb's ideas on turkey economics and Mandelbrot's fractals and invariance of time scales.

Overall it was an excellent read - covers a lot of ground on bleeding edge modern and future thinking. I recommend this book to any one with an interest in strategy, finance or economics.

Genetic evolution & Risk management

I was recently hooked to reading up on genetics and evolution. My thoughts revolved around how life evolves and adapts to environmental surprises. Surely the fact that we see so much variety around us must have its roots in ingenious risk management. Three aspects struck a chord. The first - impefect self replication,  making risk taking an essential aspect of evolutionary progress. The second - built in redundancy and ability to self repair - you cannot take down the house even under the most dire circumstance - No Amarynth style nat gas bets here. Its built to re-evolve re-adapt and ignore and or correct most deficiencies. The third one blew my mind - create almost anything needed with the same building blocks. Its like the most perfectly written computer program anyone could ever imagine. It leads one to wonder who might've been the programmer.
 

To get to the grind - it starts with the building blocks of life - a cell. Almost every living thing is made up of one or more of these little things. Within each cell there are chromosomes {colored bodies - so called because they can be pigmented by certain dyes}. chromosomes in turn contain - you surely heard of this one - DNA, those double helix strands {made of sugar and phosphate running anti-parallel to each other} and four different types of nucleotide bases Adenine, Thymine, Guanine and Cytosine commonly refered to as ATGC. The DNA itself is composed of extermely long strands with different sections. Each section is a gene. Within each gene there are both coding and non-coding sequences. The coding sequence determines what the gene does and the non-coding sequences determine whether or not the gene is active.

During the process of cell division, the genetic strands of the DNA separate and create a copy of themselves. This copy is imperfect - meaning most genetic sequences are preserved but nothing in nature is perfect. There is some room for variation. This is the reason we have such a variety in organisms around us today. Unlike what many people may tend to believe that - "environment drives evolution", the cause and effect is not so clear. Evolution (continuously) takes its chances and it just so happens that some risks have greater rewards than others and result in successful survival of the new/modified species. This can be compared to portfolio diversification with high positive skew.

We can get a rough estimate the extent of risk taking involved. Each change virtually takes a lifetime. This lifetime is different for different species. However in terms of universal time its actually very short. Current estimates of universal time since the big-bang tend to be anwhere from 13-15 billion years based on the cyclical expansion and contraction model of the universe and the earth is anywhere from 4.5 to 7 billion years old. One life time for most species (even if they live to 150 years or even a 1000 years for some large trees) is a fraction of the total time in the evolutionary scale. In addition there have been large scale destruction events like comet strikes, meteor showers or super volcanic eruptions which have caused entire existing species to disappear - the dinasaurs are a good example. However this hasnt meant that life never evolved after that. It may not have had the same shape or form but evolve it does. This attests to continuous micro-risk taking with a lot of redundancy built in for large tail events.

There is also an other interesting fact which alludes to risk taking necesssary for evolutionary development. It is that all life forms have the same genetic material. The genes are actually "inter-operable" across organisms (includes any living or border-line living thing from virus to bacteria to plants, insects and mammals) in computational parlance. The fact that we see so many species surviving so successfully and in many cases in a co-dependent manner within mini or large eco-systems speaks to the extent of success (rewards) this evolutionary scheme has had for taking those risks.

Protiens, considered essential for creating mass, are composed of amino acids. There are different amino acids but they all share a common feature - that each protein requires only three neucleotide bases to build them. Based on this one might expect 4*4*4=64 different types. But no there are actually only 20 of them. The reason for 20 and not 64 amino acids is that many combinations of ATGC result in the same protein giving a lot of built in redundancy. Note the lack of "optimization" and "efficiency" that most corporates tend to focus on. The same can be said of resistance to genetic diseases. Genetic diseases are transmitted across generations only through the x-chromosome. However since the female has 2 x-chromosomes, only if both parents were carriers can the disease be expressed in a female child infant. If only one parent is a carrier, the genetic disease will be carried by the female infant but the healthier x-chromosome will take over and prevent the disease from being expressed in the female child infant. This points to the fact that even if there is a defect, it will be overidden by a gene that has no defect. Redundancy is just built into the system at every point.

Back to cells. To create something like for example a body part the first step is transcription where the DNA creates a copy of a specific sequence of its own one strand and replaces the T (Thymine) with U(Uracil). This single strand structure is called messenger RNA or mRNA. Each such coding sequence codes for atleast one gene. The mRNA acts as an encoded message instructing the build out of protein and so on. It is no moot point for the same material to serve as container, carrier, creator and created. This self evolution is the very essence of life itself. It re-inforces the need to have self contained modules or units at as granular a scale as possible that can be generalist enough to evolve into doing anything specialist based on the needs of the moment.

One can conclude by thinking about how the same evolutionary technique can be applied to portfolio management or even management of organisations. The long term rewards of taking many small risks with positive skews on a continuous basis with sufficient capital set aside to prevent bringing down the house in tail events may far outweigh using capital "efficiently" or "optimally".

"Greece is no Lehman Brothers" - Are you sure?

There was a recent article on Bloomberg stating that some "analysts" at Blackrock and some other institutions were touting a buy recommendation on soverign Greek bonds. Their premise was - "Greece is no Lehman Brothers". My thought upon reading this was - that line is uncannily familiar. In fact I read a similar line in the media when Bear Stearns collapsed and there was some speculation around the fate of Lehman Brothers. Some one said - "Lehman is no Bear Stearns" - Really?  Somehow there seems to be a general lack of discipline in differentiating fact from opionion. Using opinions as a premise is a very common fallacy.

What may seem surreal ex-ante may actually be real ex-post. Now it could be the case that "Greece is no Lehman brothers", but as of now one knows that for sure. Remember the Russian default more than a decade back ... the investment community in general seems to have a very short memory

Will PIIGS sh(r)ed the Euro?

The EUR (Euro) was originally concieved to challenge the USD's status as a reserve currency or at least provide a viable alternative . The economic idea behind this is the following: The collective GDP of the Euro zone countries matches the GDP of the united states. If the Euro zone acts as a single trade zone, every country that trades with one or more country in that region will automatically try to move part of their foreign reserves to EUR. This increases convenience and reduces hedging costs for a trade partner country, relative to maintaining a basket of currencies or alternatively converting at the given spot rate to the required currency when there is an import need. Strategically choosing a reserve currency also demands a capability based approach - What country, or in the Euro zone case - collaboration of countries, can provide me with my critical need in times of crises. There is also an issue of trust involved. Can I rely on the country issuing the reserve currency, not to unduly depreciate its value (No quantitative easing).

Why the EUR could be a better choice as a reserve currency: With GDP as a parameter the USD and EUR are comparable. Under the strategic choice criteria, currently USD has an edge. However with the issue of trust EUR has an significant advantage. The reason being that its harder to get an agreement among all partner nations to pressure the European central bank (ECB) to print more Euros than it is to get the Federal reserve (FED) to print more through political jawboning by the US congress.

Now what seems like a strength for the Euro, is also unfortunately its main weakness and we are currently witnessing live action on this front. Within the Euro zone - the monetary and fiscal policies are decided separately. Interest rate setting is the job of the ECB which is politically dominated by the two strongest economies in the Euro zone i.e. Germany and France, while the fiscal policies are decided by each partner country and local politics prevail.

As with other things in life what is globally optimal may not be locally optmial and vice-versa ie. - Whats good for Portugal, Italy, Ireland,Greece & Spain (PIIGS) is not good for Germany or France. Portugal, Italy... and the rest that are currently in deep economic distress have to spend their way out of trouble. To do this they have to resort to public borrowing. There are two ways to finance public borrowing - 1) Increasing taxes - Which is political suicide in economically challenging times 2) through quantitative easing or future inflation. Now a combination of the two options is usually a safer (and smoother) approach with option 1) being postponed to the future for when the economy picks up. But unfortunately for the PIIGS there is no easy way to adopt option 2). They are at the mercy of their partners. No soverign country wants to be at the mercy of any other. Also not having option 2) increases sovereign risk and hence increased costs of option 1). Not being able to issue bonds in a currency that a country can print makes these 'developed' nations similar to 'developing' nations borrowing in USDs.

So - Will PIIGS sh(r)ed the Euro ... We'll have to wait and watch.

CVA Adjustments - Bubble in the making!!

With the recent financial turmoil of 2009 (which I hope is behind us), a new regulatory fad that has caught on in wall street is the CVA or Credit valuation adjustment. If you are not a financial junkie and a main streeter - which in otherwords means a good person :), CVA is just a fancy term to recongnize the fact that whatever assets (of the financial kind, that cannot be touched, felt or used for personal gratification outside of adrenalin kicks and missed hearbeats as it goes up and down in value) you own is worth anything only if the party that you purchased it from is going to honor its committment to pay. Hence the asset value should be reflected on the books at a discount to its current market value to reflect the fact that when the moment of truth arrives and your payment is due the other party ain't broke. Now all this seems like a step in the right direction.

However the funny part is that increasingly the same principle is being applied to liabilities as well. The rationale being offered is that if I owe you something and I know I am going broke - well, I probably don't owe you anything. This is being touted as bi-directional CVA. I believe this is just egregious to say the least and another shenanigan that's almost surely goign to land us in trouble and feed into an accounting P&L bubble. For the uninitiated, asset price changes over a year less liability price changes over a year = P&L for that year. If liabilities decrease, your P&L will increase. However using the fact that you may go broke and not honor your commitments to increase your P&L is just plain wrong (ethically and otherwise) as it challenges the viability of the firm as a "going concern".

Now there is an element of truth to the fact that there is a good chance that you may go broke before the other party does, in which case the other party's default has little or no consequence to you. My take on this is that, this fact can be reflected by adding a small premium to the discounting effects of the CVA adjustments to the assets only (not liabilities) by using a CVA adjustment based on a conditional probability of default. ie. counterparty probability of default conditioned on your survival. This will be identical to the implied default probabilities reflected in credit default swap spreads, where a third party purchases a credit default swap (CDS) from you where you are the protection seller and the issuer is your counterpart from whom you have purchased assets (This is a theoretical equivalence). The liabilities, I opine, should be valued at their full price.

This is a much more realistic and conservative approach than the one that is currently being touted. Some might argue that you can hedge away your liability risk - which might let one think there is some credence to the claim of bi-directional CVA. However this is, as many risk practitioners know, a moral hazard. Think of this as buying a put option on your liabilities. No sane counterpart should or would allow you to hedge away your liability risk.

Hope the SEC is watching ...

Books that I RRLR'ed {Recently Read, Liked and Recommend}

Author: Jared Diamond {Coverage: Evolutionary Biology and its relation to Geography Climate and Human evolution in general}

1)Guns Germs & Steel {Just outstanding... I could not stop reading this one}

2) The Last Chimpanzee

Author: Malcolm Gladwell {Philosophy: How little things can make a large difference, Why a small edge can lead to great Success}

1)The Tipping Point

2)Outliers

3)Blink

... Anything else he can or will write

Author: Nassim Nicolas Taleb {Philosophy: Why tail events are so hard to predict and why they are extremely important - Turkey economics. The dichotomy of efficiency vs. robustness and much much more}

1) Fooled by Randomness

2) The black swan

Note: Dr. Taleb also happens to be my professor and has been a great infulence on my interest in extreme events and probability. You can gain insight into some of his views @ http://www.fooledbyrandomness.com/

Author: Gary Hamel {Content: Mostly management - Collaboration over competition, Democracy as a management style}

1) The future of Management {Managing innovation and betting for success}

2) Competing for the Future {with CK Prahlad}

Author: Phil Rosenzweig

1) The Halo effect: and the Eight Other Business Delusions That Deceive Managers {Philosophy: Why one must not confuse causality & correlation}

New Beginnings

The articles in this blog will be dedicated to random issues of interest which could on occasion have ephemeral significance. The views and thoughts expressed in these snippets are meant for general purspose reading and amusement.