In short, diversification strategies by individual firms generated a lack of diversity across the system as a whole. So what emerged during this century was a financial system exhibiting both greater complexity and less diversity. Up until 2007, many participants in financial markets would have viewed that network evolution as the inevitable by-product of technical progress in finance. Until then, complexity plus homogeneity equalled stability. But in just about every non-financial discipline – from ecologists to engineers, from geneticists to geologists – this evolution would have set alarm bells ringing. Based on their experience, complexity plus homogeneity did not spell stability; it spelt fragility. In understanding why, it is useful to explore some of the wider lessons from those disciplines, taking in turn the effects of complexity and diversity on stability. Complexity and stability Tropical rainforests are a complex adaptive system. In the immediate post-war period, these eco-systems were often used as a case-study when demonstrating why complex systems tended to exhibit greater stability. 3 In Elton’s (1958) words, this was because there are “always enough enemies and parasites available to turn on any species that starts being unusually numerous”. Complexity strengthened self-regulatory forces in systems, so improving robustness. This was the prevailing ecological wisdom up until the early 1970s. That conventional wisdom has since been turned on its head. From the 1970s onwards, orthodoxy was altered by a combination of enriched mathematical models and practical experience.
But the second is likely to be variable and sociological. In other words, agents’ responses to infection, or indeed the fear of infection, are often crucial in determining its rate of transmission. In practice, these behavioural responses typically take one of two forms: “hide” or “flight”. For example, the response to the SARS epidemic in the 21st century was a “hide” response, with people self-quarantining by staying at home and with flight, in this case literally, prohibited. But the response to yellow fever in North America in the 19th century was “flight”, with half the population of Memphis fleeing in 1878. 15 Either response is rational from an individual perspective. Both responses have the aim of removing that individual from circulation with other, potentially infectious, agents. But the implications of these responses for infection rates across the system are potentially very different. Hide responses tend to contain infection locally, thus protecting the system globally. This was the SARS experience. Flight, by contrast, tends to propagate infection globally. This was the yellow fever experience, as incidence of the disease followed the railroad line out of Memphis. 16 During this financial crisis, faced with fears about infection, similar sets of behavioural responses by financial institutions have occurred. Only the names are different. The “hiding” has taken the form of hoarding, typically of liquidity. And the “flight” from infected cities has taken the form of flight from infected assets, as institutions have sold toxic assets.