An Evolutionary Approach to
Financial History
Gresham Special Lecture
June 2, 2009
The Economist said it
“It is a Darwinian world.”
(Economist, February 16, 2008)
Tony Ryan said it
“Just as some species
become extinct in
nature, some new
financing techniques
may prove to be less
successful than others.”
(Assistant Secretary of
the Treasury for
Financial Markets
Anthony W. Ryan before
Congress in September
2007)
Goldman Sachs said it
“The Evolution of Excellence”
(Conference in London, November 2005)
Darwin himself intuited it
• On the Origin of Species
(1859) partly inspired by
Malthus’s Essay (1798)
– “Being well prepared to
appreciate the struggle for
existence … it at once struck
me that under these
circumstances favourable
variations would tend to be
preserved, and unfavourable
ones to be destroyed. Here,
then, I had at last got a theory
by which to work.”
– “principle of divergence”—
from Smith’s division of labor
Thorstein Veblen proposed it
“The economic life
process [is] still in
great measure
awaiting theoretical
formulation” (“Why
is Economics Not an
Evolutionary
Science?” Quarterly
Journal of Economics
(1898))
Schumpeter hinted at it
“This evolutionary ... impulse that
sets and keeps the capitalist
engine in motion comes from ...
the new forms of industrial
organization that capitalist
enterprise creates. … The ... same
process of industrial mutation …
incessantly revolutionizes the
economic structure from within,
incessantly destroying the old
one, incessantly creating a new
one. This process of Creative
Destruction is the essential fact
about capitalism.” (Capitalism,
Socialism and Democracy (1943),
pp. 80-4)
Some economists have tried it
• Alchian, A.A. (1950) “Uncertainty, evolution
and economic theory”. Journal of Political
Economy 58: 211–222
• Nelson, R.R. and Winter, S.G. (1982) An
evolutionary theory of economic change.
Harvard University Press, Cambridge, MA
And perhaps its time has come
• Andrew Lo at MIT: “Hedge
funds are the Galapagos
Islands of finance ... The rate
of innovation, evolution,
competition, adaptation,
births and deaths … occurs at
an extraordinarily rapid clip.”
• “As with past forest fires in the
markets, we're likely to see
incredible flora and fauna
springing up in its wake.”
• “Adaptive markets”
But Hilferding still looms large
• The legacy of Rudolf
Hilferding’s
Finanzkapital (1910)
• Concentration and
consolidation in
financial services as
an inexorable process
of exploiting
economies of scale
and scope
An evolutionary process?
Evolution as seen by Citigroup
A real evolutionary process
Evolution as seen by Darwin
The evolutionary analogy
• Competition for finite resources – customers, clients
• Potential for spontaneous mutation – innovation
• Mechanism for natural selection – through the
market allocation of capital and human resources –
and possibility of death in cases of underperformance (differential survival)
• Scope for speciation and hence sustained biodiversity
• Scope for species extinction
• Genes – institutional memory of business practices
Recent trends in financial evolution
• Instruments
– Mortgage-Backed
Securities
– Other Asset-Backed
Securities
– Collateralized Debt
Obligations
– Collateralized Loan
Obligations
– Derivatives
• Institutions
– Hedge funds
– Private equity
partnerships
– Sovereign wealth funds
– Conduits
– Structured Investment
Vehicles (SIVs)
– Bond insurers
– “Shadow banking”
Source: Oliver Wyman
Source: Oliver Wyman
The first hedge fund was set up in
the 1940s to allow savvy investors
to bet against stocks by taking socalled “short” positions.
The Long Term Capital
Management debacle
didn’t stem the rise
Source: Hedge Fund Research
Hedge fund assets and positions
Source: Lo Testimony (2008)
Asset backed securities
4,000
3,500
Mortgage-backed and asset-backed securities in the U.S. ($bn)
3,000
2,500
2,000
1,500
1,000
500
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
0
Ginnie Mae
2,500
Fannie Mae
Freddie Mac
2,000
1,500
1,000
500
0
1995
1996
1997
Auto
1998
Credit Card
1999
Equipment
2000
2001
Home Equity
2002
Manufacturing
2003
Student
2004
Other
2005
2006
Derivatives
450,000
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
Notional Amount Outstanding($ BN)
Over-the-counter derivatives outstanding ($bn)
Interest rate contracts
Foreign exchange contracts
Equity-linked contracts
Commodity contracts
CDS
Other
Source: Oliver Wyman
The differences (part 1)
Eating and sex
• In finance, mergers and acquisitions can lead directly
to mutation
– Unlike in the natural world, where it’s just plain eating
when one organism ingests another
• In finance, there’s no counterpart to the role of
sexual reproduction in the animal world
– Though there may be asexual reproduction, as when
people leave Goldman to set up multiple hedge funds
• In finance, most mutation is conscious innovation,
rather than random change
– So it’s more a Lamarckian not a Darwinian process
The differences (part 2)
Man-made catastrophes
• Sudden environmental changes can render certain
evolved traits disadvantageous where previously
they had been advantageous, and vice versa
• But financial disruptions are unlike asteroid strikes
and ice ages because they are endogenous not
exogenous
– Great Depression of the 1930s
– Great Inflation of the 1970s
– “Great Repression” of the 2000s
The differences (part 3)
Intelligent (?) design
• In the natural world, there are no regulators; in
finance there is supposed to be “intelligent design”
• But regulators focus on consumer protection and
systemic risk, not optimizing evolution
• Most regulations have the effect of shutting the
stable door after the horse has bolted
• The risk is that regulation impedes or distorts natural
selection
A brief history of the crisis
Global imbalances ...
Current account balances as percentages of global GDP
2.5
2.0
1.5
1.0
Oil exporters
Emerging Asia
Japan
Euro Area
United States
0.5
0.0
-0.5
-1.0
-1.5
-2.0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
... and monetary policy errors ...
... and excessive leverage ...
US sectoral debt
as a % of GDP
120
100
80
Households
Non-financial Business
All Government
Financial Sectors
60
40
20
0
1974
1979
1984
1989
1994
1999
2004
... and financial engineering ...
ABX.HE.AAA.07-2 (20 MBS)
High 99.33 Low 23.1 Coupon Maturity 25JAN38
“In January 2008, there were 12 triple A-rated companies in the world. At the
same time, there were 64,000 structured finance instruments, such as
collateralised debt obligations, rated triple A.”
-5
-10
-15
-20
-25
January 2008
January 2007
January 2006
January 2005
January 2004
January 2003
January 2002
January 2001
January 2000
January 1999
January 1998
January 1997
January 1996
January 1995
January 1994
January 1993
January 1992
January 1991
January 1990
January 1989
January 1988
... caused a property bubble
Case-Shiller national indices, annual rate of change, 1988-2008
25
20
15
10
5
0
Composite-10
Composite-20
… rendering some big banks insolvent
Source: Financial Times
We’re avoiding the 1930s …
... with monetary expansion ...
… and fiscal stimulus
Inflation v. deflation
• “A policy mistake made by
some major central bank
may bring inflation risks
to the whole world ... As
more and more
economies are adopting
unconventional monetary
policies, such as
quantitative easing, major
currencies’ devaluation
risks may rise.” (Chinese
Central Bank, quarterly
report)
•
•
•
•
•
•
•
Output gaps (IMF) for
Japan
-8.0%
Germany
-5.8%
UK
-5.5%
Italy
-5.1%
France
-4.5%
Canada
-4.3%
U.S.
-4.1%
It’s Godzilla v. King Kong
What happened in the Thirties
What’s happening today
A case of arrested evolution?
A last word from Schumpeter
“This economic system cannot
do without the ultima ratio of
the complete destruction of
those existences which are
irretrievably associated with the
hopelessly unadapted. ... An
indiscriminate and general
increase in credit facilities
means simply inflation ...
[which] destroys that measure
of selection which can still be
ascribed to the depression, and
burdens the economic system
with ... those firms that are unfit
to live.”
Joseph Schumpeter, Theory of
Economic Development (1934)
Conclusion
• As a metaphor, evolution offers better insights
into the processes driving financial history than
models of concentration derived from Hilferding
• The financial world does appear to be
characterized by (Lamarckian) mutation and
(Darwinian) natural selection
• But “intelligent design” by legislators and
regulators impedes the evolutionary process
• Schumpeter’s view still stands: “creative
destruction” is integral to economic evolution