Complexity and Resilience Rating

adventure!

Foreword

„Complexity can be measured".

When the author and I firstly met in 2012 thanks to the Wikirating project and due to our criticism of rating agencies, I could not imagine how interesting and profound the exchange would become with this brilliant thinker and visionary.

We both share the conviction that the conventional and popular theories and models describing the economical world are not adequate – especially if one wants to better understand our quickly changing world and society.

It is an undisputed fact that our world is becoming more complex, unclear and incomprehensible. More than ever concepts based on either traditional optimization or gut feeling are less useful in terms of helping to understand our world and act appropriately.

This book touches some of the most actual and unsolved topics regarding the economy and the financial world and offers new paradigms for dealing with them.

Starting with a summary of the quantitative theory of complexity, the book proposes clear and simple examples of the new concept of resilience rating as applied to countries, companies and financial products. The resilience rating is universally applicable and provides better understanding of the behaviour of economical systems or financial products, measuring how well they can withstand shocks and turbulence. This new approach does not use the commonly known „Probability of Default" approach – it goes beyond the concept of probability.

With the aforementioned approach the author analyses astutely the overall health of the global economy as well as of the Eurozone. Some results obtained this new quantitative approach provide quite surprising insights. For example, some aspects of the Italian economy are more resilient than that of Germany.

Beside systemic investigations the book covers also completely new complexity-based strategies as to monitoring and assessing portfolios and markets.

Since complexity can now be measured, thanks to this book the reader may benefit from the many new insights which it can offer.

Dorian Credé

Zurich, August 2015

Acknowledgements:

I would like to gratefully acknowledge the incessant collaboration of my friend and business partner Giuseppe Graci. His work and unreserved support over the past decade has laid the foundations for much of the material presented in this book and has provided invaluable intellectual stimulus.

Preface

The economy is a dynamic system which is far too complex for us to understand. Human nature is extremely complex and billions of irrational humans form the economy. How can such a system ever be thought to be efficient, in equilibrium and stable – as many prominent economists have claimed? But this system, like every other natural or man-made system, must respect the non-negotiable laws of physics, even if they may be unknown at a given time. One of the instruments that have enabled the 2008 crisis are sophisticated math models. There was nothing in those models that would even hint catastrophe because models can only tell you what you hard-wire into them. The construction of placebo-generating models has lead to a Panglossian approach to finance and the economics which excludes extreme events and catastrophes, allowing bubbles to grow and Ponzi schemes to flourish. So failure was not contemplated in the models. And there are no model-building laws that would force one to do so.

Models are based on assumptions. Hence they are disputable and, at the same time, provide an enormous margin of manoeuvre. And, when needed, impunity. There are no universally accepted laws on building math models. Sure, you can dream up an equation and claim that it provides a basis for the pricing of some derivative. And then have people invest based on it. You cannot be held accountable simply because you are using an equation that one day implodes. You cannot take mathematics to court but you can put in prison an engineer or a doctor who is responsible for the loss of lives. Why is that? Because physics is not an opinion, while financial mathematics, together with its underlying assumptions, is. Just because you manipulate equations according to strict rules doesn’t mean you’re doing science. You could just as well be playing an extravagant video game which has no relevance or reflection in anything that is physical and that really exists. The fact that we are still unable to fix the mess, even though everything went off the rails almost ten years (and many trillions of dollars) ago, just goes to show how little we understand the economy, its systemic aspects and its dynamics.

We must change approach radically. When you face a super-complex system which you don’t understand – the crisis proves that we understand the economy very little – do you model very precisely a tiny subset thereof or do you try to get a global coarse picture of the situation? Isn’t it true that the closer you look the less you see? The Principle of Incompatibility states that high complexity is incompatible with high precision. This means that the economy – which is evidently very highly complex – cannot be modelled precisely and that all effort to squeeze decimals out of math models is futile, even though sometimes this gets you into the Nobel zone. In actual fact, the more complex models one is conceiving the more assumptions one must make. And that means more risk and, at the same time, more freedom to steer your model in a desired direction. From a practical and physical standpoint, what is the difference between AAA and AA+?

So we need to change paradigm. Less hair-splitting, less fiddling with decimals and unlikely probability distributions or Brownian motion. Things have gotten very complex and we must place science not mathematic alchemy at the centre of our thinking.

The Probability of Default (PoD) of a company is the central concept behind a rating and ratings are a key link between the markets and investors. Their importance cannot be overstated. However, the PoD is not a physical quantity and there exist very many ways of computing it. Each method has its own assumptions – the degrees of freedom are phenomenal. Not only is a PoD a non-physical quantity, it is also highly subjective. In fact, rating agencies themselves claim that ratings are merely opinions. In mechanical engineering, for example, things like mass, strength, energy, stiffness or margin of safety are computed according to non-negotiable laws of physics which are the same all over the World. The PoD does not obey any such laws. It may have become a sort of a standard but it is not the result of any law of physics. This means the PoD must be replaced by something more rational and relevant. Something that not only has its roots in physics, but which is also more in line with the turbulent character of our times. Let’s not forget that ratings have been conceived a century ago. The world was very different then. Conventional business intelligence and analytics technology have become dangerously outdated and, most importantly, it is not well suited for a turbulent economy. As the complexity of the economy increases, traditional analytics produces results of increasing irrelevance. Mathematically correct but irrelevant. The solutions presented in this book have been architectured specifically for turbulence and for an economy dominated by shocks, destabilizing events and instability. Markets are not efficient. In nature there is no such thing as equilibrium.

So, instead of a PoD-based rating, we propose a complexity and resilience-based rating. High complexity is, with all likelihood, the most evident and dramatic characteristic of not just the economy but also the hallmark of our lives. Resilience is the capacity to withstand extreme events and is a measurable physical quantity – there are standard tests in engineering to determine the resilience of materials – and resilience rating is applicable to companies, stocks, portfolios, funds, systems of companies or national economies. In our turbulent economy, which is fast, uncertain and highly interdependent, extreme and sudden events are becoming quite common. Such events will become more frequent and more intense, exposing fragile businesses to apparently unrelated events originating thousands of kilometres away. This mandates that companies and investors focus not just on sheer performance but also on resilience, building less complex less fragile businesses. Resilience means survival and sustainability. Resilience is science, not opinions.

Jacek Marczyk

Lake Como, August 2015

Chapter 1:

Introduction

Probability is the most important concept in modern science especially as nobody has the slightest notion of what it means.

Bertrand Russell.

To predict the future has always been a dream of all peoples. Clearly, predicting the future is impossible. The reason lies in the non-deterministic character of matter which is reflected in the dynamics and the patterns of Nature. Because of this very fact, the future is permanently under construction and, therefore, the prediction of the future is out of the question. There is an overwhelming amount of evidence in support of this fact. If the future were predictable we would have different laws of physics and life would probably not even exist. But humans are a stubborn species. Man neglects hard facts and scientific evidence. However, the unhealthy desire to predict the future has pushed mathematicians to devise utterly unnatural methods which, in virtue of prolonged and often distorted use, are now deeply rooted in the minds and practices in virtually all branches of science and the industry. What cannot be achieved should not be pursued. Our efforts should be focused on real problems that admit real solutions.

One attempt to understand Nature is via statistics, by searching patterns in data and then trying to extrapolate future events based on such patterns. Unfortunately, this simplistic attempt is doomed because the predictive power of statistics is limited. Statistical models are not only a poor caricature of reality – they also do a great job of distorting it as they can generate dangerous placebo effects. In reality, statistical models used by economists, analysts, engineers as well as doctors all suffer the same fundamental flaw – you cannot take a series of apparently similar events and make the assumption that they all belong to the same class or set and then throw some regression model on top in order to derive a predictive law. Consider for example a set of patients being examined for cardiac infarction risk. Doctors will attempt to group patients into homogeneous classes before performing any statistics: sex, age, presence of diabetes, smoker/non smoker, etc. And yet, such classes cannot really exist. No two individuals have the same clinical history. One may have been an alcoholic while the other may suffer from blood coagulation problems. Because of the existence of irreversible processes and different personal histories, no two patients will fall into the same category. Clearly, if one is willing to close an eye on certain aspects that appear to be marginal then an approximate model may indeed be constructed and homogenous classes will be possible. But this is precisely the point we’re making – reality doesn’t work like that. Nature doesn’t always pardon approximations and Nature doesn’t work based on models. It creates structure and complexity in the face of the destructive forces of entropy without resorting to mathematics or mathematical models. The whole idea is precisely to survive without knowing the future. In evolution, uncertainty is necessary in order to fuel creativity. This, in turn, leads to adaptability which is the key to survival. Therefore, uncertainty means survival. Unfortunately contemporary mathematics (and science in general) is not able to capture this very essence of Nature. One could, however, argue that mathematics has contributed in a fundamental measure to most of humanity’s achievements. True. There does indeed exist a plethora of elegant approximations – the majority are linear – that can help understand better many phenomena but they do not explain the intimate nature of things. Our math is unable, for example, to describe a cloud, or a leaf. Not to mention life and its fundamentals. Life, the most unusual mystery of our Universe, lies well beyond the limited reach of not only conventional mathematics but outside of contemporary thinking and science. We know how to heal certain diseases but that does not mean that we understand the hugely complex and intricate dynamics of the human body. Just because a certain statistical model reflects some simple patterns of our economy it doesn’t mean that we fully understand it. In actual fact, the 2008 economic meltdown is an eloquent proof of the contrary. At this point we also stumble on the issue of ethics. Suppose that one devises a totally wrong