the cybernetic history of the crisis

viable systems and central banking

IT'S PUBLICATION DAY!!! WOOHOO!

“The Unaccountability Machine” is now available to buy! Physical copies will ship to the USA, I think, it just might take a little while. Please do buy it if you have the budget - this is as complete a statement of the ideas of this newsletter as I'm likely to ever be able to make.

if you are on the fence, Henry Farrell's review is far more perceptive and intelligent than I deserve. There will also be a capsule summary in Marc Rubinstein’s newsletter, where I'm doing a Collab this week (sort of like Cillian Murphy x Versace, but more stylish and beautiful).

Readers with early commutes or farms might have heard me on Radio 5’s “Wake Up To Money” this morning, talking about the Bank of England forecasting review in a pluggy context. In honour of that, here's a book extract, on how the Great Financial Crisis makes so much more sense if you view it as a failure of information processing systems…

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Central banks are the institutions to which the task of controlling the monetary system is assigned. They have a variety of operations, which need to be managed, regulated and integrated – they might set interest rates, supervise the banking sector and intervene in foreign exchange markets, among other functions. The governing statute of a modern central bank is a sort of resource bargain in terms of the delegation of power over policy, in return for keeping inflation stable and keeping the monetary part of the economy functioning. The central bank is allowed independence, conditional on promising not to cause so much economic damage that it imperils the political stability of society as a whole. In other words, it’s an operational subsystem of the government’s wider task of economic management.

And central banks need to be viable systems themselves, with all the building blocks of balancing subsystems, communications channels to connect them and the red-handle warnings that respond to threats. When that doesn’t happen, things break down; conversely, when something bad has happened, you should be able to explain why the system became unregulated.

During the 2000s, for example, the world’s central banks thought everything was fine – they made up nicknames for the period of stability that lasted from the end of the dot com bust to the collapse of Lehman Brothers. Alan Greenspan of the US Federal Reserve called it the ‘Goldilocks Economy’ – not too hot, not too cold. Mervyn King of the Bank of England called them the ‘NICE times’, an age of non-inflationary continuous expansion, And Larry Summers of the US Treasury referred to the ‘Great Moderation’. All the while, a huge debt bubble was building up, with house prices spiralling out of control.

What’s surprising is not that the housing bubble burst, or that its debt financing turned into a massive wave of bankruptcy, but that the central banks were taken by surprise. The American housing market peaked in 2006. In 2007, the defaults began to grow, the investment bank Bear Stearns had to be rescued and a few of the more aggressively leveraged financial markets were shut down. But there was hardly any coordinated policy reaction until the bankruptcy of Lehman Brothers on 15 September 2008.

This ought to immediately alert us – the problem was not in the “here and now” operations, it was in what Stafford Beer calls System 4, the ‘elsewhere and future’ intelligence function. Absence of or weakness in this system is one of the most common problems in organisations, and central banks have a few quirks that make them particularly vulnerable. Their aim is to keep a small number of target variables within a relatively narrow range, while also ensuring that there isn’t catastrophic breakdown in the system as a whole. That requires an operational system to implement and integrate those actions of the central bank which involve intervening in markets and making regulations, and an intelligence function that looks ahead to see whether structural changes in the economy might require a reorganisation of those policy actions.

It looks like that’s what central banks do; make forecasts of the future, publish them and update them as the situation changes. But their forecasts are their version of ‘here and now’; when you hear them talking about inflation targeting, they mean inflation forecast targeting. Interest rate changes affect the economy with a lag, so they need to be implemented on the basis of the expected path over a period of time – not just on what’s happening on the evening news.

If something isn’t in the forecast, it isn’t part of the information set and can’t affect the decisions – which is why central banks try to supplement their economic and statistical models with other data sources. But there’s a more subtle problem – if you’re doing all this forecasting, it’s hard to believe anyone who tells you that you’re not looking to the future.

A real intelligence function, though, is explicitly concentrated on those parts of the environment that *aren’t* yet relevant to what it’s doing. This capability was weak in the central banks; they were not looking for things which might have upset their policymaking framework. The information was there, but it hadn’t been organised into the decision-making process and didn’t shape the view at the management or operational levels. It remained as ‘other data’ or was attenuated away by simply ignoring it; the ‘information processing system of last resort’. Only when a red handle had to be pulled – what Stafford Beer might have called the ‘unignorable scream’ of the Lehman Brothers bankruptcy – was the huge information handling capacity implicit in the central bank’s powers brought to bear.

Over the course of the Great Moderation, the central banks developed a view of the world in which the changing structures of global finance weren’t part of their job. They didn’t pay attention to the debt bubble, and they had got rid of the communication channels that might have carried the red-alert warnings up to the highest levels of policy making. More precisely, they had got rid of the translation systems. There was no shortage of people warning that there was a problem in 2006 and 2007, but none of these warnings was given in a form that could be recognised by the world’s central bank governors as requiring action.

Where things went wrong was a matter of philosophy. The central banks had an identity-creating function, but it had gone wrong; it defined their purpose in such a way that they failed to understand that particular kinds of information were relevant to them.