On the global financial crisis: system reliability should take precedence over efficiency

[I am posting this old piece because of its direct relevance to the 2008 global financial crisis. It was first distributed in 2001 and subsequently included as Chapter 23 in my book Towards a Political Economy of Information.] The gist of this piece is the proposal to make reliability as important a criterion for decision-making as efficiency. The piece provides the theoretical basis of such policies as economic protectionism, import/export control, capital flow regulation and other State regulatory tools.]

In an earlier letter to the Human Ecology Review[2], I proposed reliability as an alternative criterion for socio-economic decision-making instead of efficiency. This paper pursues that idea further.

Definitions

Efficiency is a measure of how well transformation of matter or energy occurs. To be efficient means to get the most from the least. The higher the efficiency, the better the transformation is occurring. Efficiency is usually computed from the ratio of useful output to input. To be accurate, the computation must take into account all inputs to a process; otherwise, the computed efficiency may exceed 100%. This will imply that the transformation process itself is creating new matter or energy, which contradicts fundamental laws of physics.

Since energy transformation always produces waste heat, the energy efficiency of any process is always less than 100%. If some of the material outputs are not usable (e.g., wastes), then the sum of the useful material outputs will be less than the sum of the material inputs too, and the material efficiency of the process will likewise be less than 100%.

Economists often express the inputs and outputs of a process in monetary terms, because their interest is in processes where the monetary outputs exceed the monetary inputs. Furthermore, economists often compute the difference instead of ratio between outputs and inputs, because their interest is in absolute monetary amounts instead of ratios. In such cases where the focus is on absolute amounts, this paper uses the term “gain” instead of “efficiency.” An example of gain is the producer’s profit, which is revenues minus costs. Another example is the total utility to the consumer of a set of goods minus the total price of these goods.

Because both are measures of output relative to input, gain is closely related to efficiency and is used whenever absolute magnitudes are more important than relative magnitudes.

Among business firms, gain is really of more interest than efficiency, the best firms being those who manage to squeeze the last marginal bit of gain (i.e., profit) from their business operations.

Among natural persons, the output of interest is not necessarily matter, energy, or money but a vaguer concept like welfare, utility, or happiness, which makes measuring efficiency or maximizing it harder.

Like firms, economies today also tend to maximize gain (i.e., efficiency and inputs), not only efficiency. To maximize gain, one can increase the inputs to a process, or the efficiency by which the inputs are transformed into outputs, or both. Expanding one’s global reach is one way of increasing inputs. The economies-of-scale argument (higher efficiency through larger scale of operations) also supports a global strategy. Thus, gain-maximization strategies directly lead to globalization.

Because economies include all firms and natural persons, macro-efficiency is very difficult in practice to maximize or even simply to measure. To cope with this problem, economists have settled on a curious rule for improving the efficiency of economies step by step: improve somebody’s welfare without reducing anybody else’s, and keep doing this until nobody’s welfare can be further improved without reducing somebody else’s. This is the economist’s Pareto efficiency, which is obviously lower than full theoretical efficiency, but is itself a theoretical construct that is hardly ever seen – not even approximated – in reality.

Efficiency and economic theory

Despite these theoretical problems, efficiency is probably the most common criterion for economic decision-making in modern society. Nearly all modern economic policies cite efficiency as their ultimate goal, even if measuring it can be quite difficult.

Efficiency is the rationale for the idea of competition in a free market. It is also the reason cited for dismantling the welfare policies of the State and the welfare state itself. It is cited as the reason for privatization programs. Advocates for the international division of labor and economies of scale cite efficiency as their goal. Globalization, which extends the economies-of-scale idea to its utmost, also invokes efficiency as reason.

When policy-makers select between alternative options, efficiency is often at the top of the list of criteria for selection.

Critiques of efficiency

The efficiency criterion has been criticized from at least three vantage points: 1) from efficiency advocates themselves; 2) from the social justice viewpoint; and 3) from the ecological viewpoint.

The first critique comes from within the advocates of efficiency itself. This critique retains efficiency as its main criterion for policy formulation, but points out flaws in the way efficiency is computed and efficiency estimates distorted, usually due to the incomplete accounting of inputs and outputs. Incomplete accounting occurs by ignoring non-market transactions or by externalizing costs.

An example of non-market transactions is subsistence production, where a considerable portion of the output is for direct consumption. Unless such production is accounted for, a subsistence economy may appear an inefficient, low-output economy. In fact, production for consumption is quite efficient because it saves marketing, storage and distribution costs. An important subset of production for direct consumption is household work, the non-accounting of which is a major critique of women’s movements against current economic systems.

Still another example of incomplete accounting occurs in U.S. agriculture, which prides itself in its increasing “efficiency,” with less than 10% of its population producing food for twice its population size. Yet, the energetic efficiency of U.S. agriculture has actually gone down over the decades: at the start of this century, it required less than one calorie input to produce a calorie of food; today, it needs more than 10 calories to produce the same amount.

Costs are externalized by passing them on to politically-weak social sectors, to the environment, or to future generations. This can lead to false impressions of high efficiency and mask gross inefficiencies within the system.

All such incomplete accounting distort efficiency comparisons.

The social justice critique

The social justice critique of the efficiency criterion suggests as a higher criterion the concept of equity. According to this critique, efficiency does not ensure equitable sharing of the output and often results in a reduction in equity (i.e., increasing gap between rich and poor).

This critique often presents efficiency as a problem of production (how to allocate input resources to maximize output), and equity as a problem of distribution (how to allocate the output to minimize the gap between rich and poor). Thus, from the vantage point of many equity critics of efficiency, maximizing efficiency and ensuring equitability are parallel objectives which may or may not conflict.

The ecological sustainability critique

The third critique of efficiency comes from the vantage point of ecology. According to this critique, efficiency only looks at a linear process that transforms input A into output B. This critique points out the problem of a linear process: the continuous transformation of input A into output B will gradually use up A and accumulate B. How will A be replaced? Where will B go? The more efficient such a linear process becomes, the faster A is used up, the faster B accumulates in the ecosystem. In a real world, a linear process is eventually an unsustainable process.

Just as the social justice critique insists that the output B must be equitably distributed, the ecological sustainability critique insists that the linear process must be turned into a cyclical one, so that the final output of the process eventually goes back to become fresh input into another – or even the same – process. This is what Barry Commoner called “closing the circle.”

A new critique of the efficiency criterion

This paper proposes a fourth critique of the efficiency criterion, from the vantage point of engineering and systems design. Such vantage point is becoming increasingly useful, since economic systems today are as much a product of social engineering and conscious design as they are a product of unplanned evolutionary development. This new critique also complements the social justice and ecological sustainability critiques of efficiency.

In engineering and systems design, another criterion for design optimization is often deemed more important than efficiency. This is the criterion of reliability.

While efficiency and reliability are related, they are not the same. Efficiency is a measure of how well a system transforms its inputs into useful output. It is usually expressed in terms of the ratio of useful output to input. Reliability is a measure of how long a system performs without failing. It is usually expressed in terms of a mean time between failures (MTBF). It may also be expressed in terms of the probability of non-failure.

Roots of the financial crisis: overproduction?

At a large meeting of civil society / non-government organizations last November 11 in the University of the Philippines campus, I was particularly interested in the presentation of the main speaker, Dr. Walden Bello, who thought that the root of the crisis was due to the “capitalist crisis of overproduction”. This analysis has its origins of course in Karl Marx’s critique of capitalism. Walden’s analysis was generally echoed by speakers like Ric Reyes and Frank Pascual, who like Walden are key personalities of the legal Philippine Left. Walden cited data showing how most Western countries had their production facilities running way below capacity. A number of the meeting panelists and participants thought it was time to wave once more the banner of socialism.

While we in the Philippine Greens are not socialists (see my post on the Green-Red dialogues), I have also been looking closely at the phenomenon which they call “overproduction” but which to me suggested “abundance” (see my posts on “abundance“). So I was interested in engaging Walden further in a discussion.

In a subsequent group discussion led by Walden himself, I presented my question framed in the following context:

I agreed that it was important to identify the roots of our current problems. (We’d be wasting much of our time and resources if we focused on symptoms rather than root causes. Worse, making a wrong diagnosis and directing efforts at wrong causes might even make the problem worse.) But I didn’t think the current crisis was due to overproduction, which typically refers to commodities and material goods. Rather, the crisis was due to “overproduction” of money and credit, particularly the latter. (I was stretching the meaning of “overproduction” here.) Governments — the U.S., in particular, because of its huge expenditures associated with the wars in Iraq and Afghanistan — were printing too much money and private firms like banks and credit companies were creating too much money. To me, all these money creation, without the corresponding blood, sweat and tears that we ordinary people have to go through to earn money, was pure theft. When someone can simply create money to exchange for things we worked hard to create or earn, they are stealing from us pure and simple. It is this “toxic” money, not associated with the production of real goods but simply created out of nothing, that leads to hyper-inflation and speculative bubbles.

Then I asked Walden what he thought of proposals which some of us in the Philippine Greens have raised to control the above, such as to return to a metallic (say, gold) standard for money, and to raise the fractional reserve requirements of banks (limiting their capacity to create credit out of nothing), and to restrict the operations of credit card and similar companies.

Walden focused his answer on the overproduction issue and reiterated his data about undercapacity in Western countries. He also said Central Banks are restricted in their capacity to print money. U.S. money was instead coming increasingly from Asian (principally Chinese) sources. He also said the gold standard was part of the Bretton Woods agreement, which U.S. President Nixon in turn abandoned in the 1970s. Since the Bretton Woods agreement carries a negative connotation among IMF/World Bank critics, I took this to mean Walden didn’t want going back to the gold standard. Unfortunately, we didn’t have time for a deeper discussion.

It seemed to me many participants and maybe even some panelists did not understand the implications of fractional reserve banking and therefore were unable to appreciate the proposals I raised. If my guess is right, then they would be in no position to understand the real roots of the global financial crisis either.

In a banking system with a fractional reserve requirement of, say, 10% (i.e., 10% of all deposits must be kept in reserve, the rest can be loaned out), the banking system can theoretically lend not 90%, as most people think, but ninety over ten or nine times (yes, 900%!) the total deposits. Where did the additional 810% come from? Out of nothing. The banks can earn real money in interest out of this credit money they created out of nothing. So while ordinary people like us have to devote real time and effort to earn a monthly income or to produce real goods to sell to the market, the rich set up banks that create money out of nothing which they then lend out to earn real money from the interest income, which they can use to hire real employees and buy real goods.

As I said, this is theft pure and simple.

Anyone who wants to understand the whole process must read about fractional reserve banking from any textbook on banking and finance.

The lower the reserve requirements, the more credit money the banks can create out of nothing. This is the source of most financial bubbles. Whether it is the dot.com bubble, real estate bubble, housing bubble, or stock market bubble, they are all in the last analysis funded by credit money which banks create out of nothing. These bubbles can exist and persist as long as people trust the system and keep their deposits in banks. Once that trust is lost, the bubbles burst, and those who cannot get out their deposits in time are left holding an empty bag (or the burst balloon).

I realized that many participants and some panelists did not understand this whole process because the proposal to adopt the Islamic banking system was raised and seriously discussed. While the Islamic system of not charging any interest is not bad in itself, it reflects the idea that charging interest itself is bad. This is a debatable point. When you lend real money (i.e., money you worked hard to earn), I think it is reasonable to charge some interest for the usual reasons (risk, overhead, etc.). But to charge interest on money created out of nothing, that’s theft.

This is what creates financial bubbles, and this is what the proposal of some Greens is directed against (I say “some” because it has not been officially adopted by the Philippine Greens).

If you want to understand the credit bubble, you must understand fractional reserve banking.

Worse than colonialism

According to most estimates, some 85% of the entire Philippine national budget now goes to debt payments – principal and interest. This is often cited as the reason more taxes, such as the VAT, the E-VAT, and now the R-VAT, have to be collected.

Consider the significance of this fact: it means that 85% of any income the government collects goes to banks, mainly to international financial institutions who are our biggest lenders. Of what remains, around half is further dissipated through corruption, going into the private pockets of politicians and bureaucrats. The little that is actually spent for social services, furthermore, may go to projects of questionable benefit to the people.

This means that every time government bureaucrats invoke the need to provide basic social services as the main reason for raising taxes, they are lying. The main reason is to pay off government creditors. Most of the tax collections will go to them, automatically appropriated.

In the 18th century, Filipinos were forced to pay the Spanish king, in one year, in cash and kind, tributes totalling around 250,000 for the entire Philippines. Of this, 187,229 pesos (74.9%) went to the local Catholic hierarchy, 59,303 pesos (23.7%) went to the local bureaucracy, and 3,467 pesos (1.4%) went to the royal treasury. Even assuming that all the Church’s share went to Spain or Rome, that plus the share of the royal treasury would still be a lower percentage of the total than the 85% that the government today hands over to our creditors.

In effect, we are in a financially worse situation today than during the Spanish era. The Spanish king has been replaced by the banks and other international lending institutions. The governor-general has been replaced by a president as their principal tax collector.

We are more exploited today than anytime in the past. The colonial period has returned, with a vengeance.

(Source: Francisco Leandro de Viana, Royal Fiscal, “Financial Affairs of the Philippine Islands”, 10 July 1766, from Zaide’s Documentary Sources of Philippine History, Vol. 6, p. 98).

An old comment haunts me

It turns out that I wrote two versions of the piece on the financial crisis I posted earlier. The other version, which you’ll find posted here, says basically the same thing but contains the following comment which now haunts me. I had written:

“Unfortunately, most economists appear to have little understanding of system design. (When I was in college, many of those who failed our engineering subjects shifted to economics.) Instead of following good principles of design, our economists repeat the most common mistake of amateur programmers: they rely on global variables.”

What a twist of irony! Although I did pass my electrical engineering course, I’m now an MA economics student in the same university where I learned engineering more than 25 years ago.

It is interesting, though, that many of the early founders of neoclassical economics, like Vilfredo Pareto and Leon Walras had engineering training.

An insightful historical analysis by Philip Mirowski (Against Mechanism) traces the development of neoclassical economics from 19th century physics, whose mathematical methods the early neoclassicals imported en toto and applied to the analysis of consumer utility, producer profit and market equilibrium. The methods of physics, Mirowski says, have changed radically since then, but neoclassical economics remains mired in 19th century physics methods of analysis. I am still trying to grasp the full meaning of Mirowski’s analysis, however.

In another piece (I don’t recall now if in the same book or another), Mirowski also commented that economics needs an algebra of its own, which also haunts me in a different way. It has challenged me to learn more about different algebras. (Aside from the more commonly-known high school/college algebra, there’s boolean algebra, matrix algebra, vector algebra, set algebra, etc.) When I mentioned this to an economist who was currently taking a PhD in Math, he thought about it for a while and then said, “actually, that’s true.”

Another area to explore.

The world financial crisis: a programmer’s perspective

I wrote the piece below some ten years ago, during the height of the Asian financial crisis. Because of its relevance to the current global crisis, I’m posting the piece here.

Globalization: poor design?

by Roberto Verzola

Most successful designers of complex systems follow basic rules of design.

Whether it is a spaceship that will land men on the moon, or a worldwide network of ten million computers such as the Internet, or a huge computer program with fifty million lines of code, or a tiny computer chip with two million transistors on it, the design rules are surprisingly similar.

One of the most basic rules in designing complex systems is called modularization. The rule says one should break up a complex system into smaller parts. These smaller parts – usually called modules – should be more manageable and relatively independent from each other. The modules should interact only through a few well-defined interfaces. Each module should have high internal cohesion. The coupling between modules should be minimized.

A good example is the Apollo lunar mission. One of the most complex systems ever made by human beings, it used modularization all through out, from the design of the spaceship itself, to the electronic circuitry that comprised much of its automatic intelligence. The mission’s spectacular success is a tribute to the effectiveness of modular design.

Another example is the Internet, a computer network designed to survive a nuclear attack. Again, the basic rule in the design of the Internet was modularization. The Internet implements communications through relatively independent network layers which interact with each other only through well-defined interfaces. Internet communications protocols have also been broken down into simpler protocols. There is a protocol for transferring mail, another for news, and still another for files.

In economics, modularization means that countries should try to become as self-sufficient as possible and as independent from each other as possible. It means that interaction between economies should be minimized and should occur only through well-defined regulations. Coupling among economies should be minimal.

Globalization, the current trend among economic planners, violates the design principle of modularization. By tearing down “well-defined interfaces” between economies, globalization increases the coupling among countries and makes countries more instead of less dependent on each other.

A complex system with high interaction among its parts becomes more prone to system failures. It is difficult to modify and to improve. It becomes error-prone, yet the errors are more difficult to identify and to correct. In a poorly-designed system, attempts to correct errors often introduce more errors into the system, making it even more failure-prone.

From a systems view, a globalized economy is a badly designed economy. It will be prone to errors and failures. It will be difficult to maintain and to improve. Attempts at correcting its failures will result in even worse problems.

Look at the problems of today’s globalized economy. Because of the free movement of goods, diseases spread quickly from one corner of the globe to another. CFCs produced in one country damage the ozone layer and threaten the health of the citizens of other countries. Toxic wastes produced in the North find themselves being dumped in the South. Chernobyl’s radioactive emissions threatened the dairy industry of the rest of Europe. A stock market crash in the U.S. would probably send stock prices worldwide tumbling. Because of the free movement of capital, job insecurity as well as speculation has become a global problem.

These are all the consequences of the bad design inherent in a tightly coupled global economy.

Despite this, economists often insist that globalization is inevitable, and the best we can do is to adjust to it.

For a designer’s viewpoint, of course, there is no such thing as “inevitable.” Every design is the result of a conscious or unconscious effort. Poor designs become inevitable only because the designer relaxes on his rules, and adopts an “anything goes” approach. To the economist, on the other hand, relaxing the rules is called “liberalization”, “deregulation”, or “leveling the playing field”. And “anything goes” is called “free-market competition”. A relaxation of the rules then makes it easy to violate the basic principles of good design, and makes globalization inevitable.

Who want the rules relaxed? These are mostly the global corporations, the main beneficiaries of globalization. They are the equivalent of global variables in software.

Software engineers try to eliminate global variables or turn them into local variables. Because global variables can easily cause changes behind the back of the system designer, they make the whole system unreliable and crash-prone. When global corporations use transfer pricing to maximize profits at the expense of the host country, or when they switch to highly automated equipment and minimize local employment, or when they compete with local entrepreneurs for skilled labor or for bank loans, or when they suddenly pull out liquid assets for some reason or another, we are witnessing what system designers call the “undesirable side-effects of global variables.” Thus a fundamental rule in system design is to avoid global variables.

Faced with a badly-designed, non-modular system, designers frequently find it easier and more cost-effective to simply junk the design and to start from scratch.

Perhaps, this is what we should do with globalization.

[From Chapter 22, Towards a Political Economy of Information by Roberto Verzola]