Financial Complexity 2

Almost six months later, I’ll look back at my earlier post about financial complexity. Considering the continuing troubles of the financial markets, it seems clear that I underestimated the degree of the problem. But I think I was generally correct in pointing out that the complexity of modern markets helped hide the nature of the bets that institutions were making. Many institutions thought that they had only a controlled amount of exposure to the mortgage market, only to find out that they were wrong. They had lent money to other institutions, which had made derivative bets, which were founded on the mortgage market, and problems rebounded back to institutions which thought they were acting soundly.

I believe the complexity has exceeded the ability of people to fully understand it at this point. That may be a general trend for financial markets–they naturally push the limits of complexity, limits which do increase over time as people learn more and develop better tools.

It remains to be seen how much this will affect the real economy. While it seems quite likely that the U.S. is now in a recession, it could still be a mild one. I suspect that some of the problems are facing now are really due to stagnant middle class income and increased health care costs–the ongoing issue of increasing inequality. At this stage of the business cycle, more people are vulnerable than usual, because fewer people did well when the economy was relatively strong.

But that need not be a bad thing. If few people do well when the economy is strong, it is possible that few people will do poorly when the economy is weak. Not very likely, perhaps, but possible. We’ll have to see.