To Make Better Market Predictions, Understand System Dynamics
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
Systemic economic weaknesses are borne of change - what worked well for one set of circumstances is often exposed as disadvantageous as those circumstances warp and twist themselves into entirely new shapes. Imperial economic and political systems, once the order of the day, led too reliably to global-scale conflict once certain technologies enabled it, and these imperial systems, therefore, had to change.
How The World Used To Work
No one sat down and planned out the global system of economic and political interface; it emerged from the complex web of interacting interests and actions that define economics and politics we take for granted each day. Countries, or nation states, as we structured them past a point, needed resources if they were to maintain their internal systems of economy, development, and security - and guaranteeing access to those vital resources meant having colonies because where those resources existed, and where they needed to go were often different places.
The colonial model was straightforward: the sponsoring country subsidized the colony’s economic development, and it got first dibs on its excess production. This necessarily implies the need for continuous expansion, and therefore, conflict because expansion involves taking resources others consider to be theirs. Coupled with the technological advancements of air power, blue water naval operations, advanced communications across distance, and nuclear weapons, this could not be allowed to reiterate. Thus, the US brought its allies together after world war two and created the Bretton Woods system, which laid the foundation for globalism as we know it today.
How The World System Was Adjusted To Work
The Bretton Woods system allowed any country included under its hospices to trade with any other member with the blessing of the United States, as well as to sell into its domestic consumer market, but it was never intended to be an economic initiative, per se. Its value to the US was about security. The member nations all agreed that in exchange for the US’ sponsorship, they would stand between the US and USSR in terms of physical conflict. In other words, the US offered not just economic recovery, but continued economic prosperity to member nations in exchange for their military alliance. And then one day in 1990, the entire reason for the agreement disappeared. The Soviet Union broke, and in doing so it removed the entire reason for the Bretton Woods system’s existence - yet the United States has kept it going over 30 years hence - until now.
Bend, Don’t Break: Fractal Analysis
This idea that something can only flex so far, at which point it breaks and can’t rebound, exists in fractal form throughout existence. Fractal, because this mechanism exists regardless of scale; every entity has some resource - whether air, food, water, or energy, without which it cannot continue to produce new value. Nearly everything in existence is fragile, in this respect - there’s a point of no return. And systems get built, more often than not, to protect against this fragility; however, the specific recipe for each type of fragility/system combination must suit a specific complement of inputs. The specific types of fragility a given system was designed to guard against, change with time; so must the system.
For example, the European Union was a new system constructed specifically to prevent strategic-scale wars from happening again on the continent, because enduring them regularly would present much too great a cost. After the limited (in hindsight) engagements fought in the world up until 1914, technology-enabled world wars one and two brought things to a whole new level of value destruction, pointing up an acute need for systemic change. How well they’ve done, history will decide, but the odds do not look to be in their favor.
The Cost Of Misunderstanding The Problem
Why do their odds appear bleak? If we look deeper, we can see the bend-but-don’t-break mechanism; the point past which the system must not be allowed to descend, or it cannot come back in its current form. This point has to do with allowing the system, in whatever form it takes, to perform its most basic functions: consume, metabolize, exchange, and excrete waste. When we take a look at those four things, it occurs that all living entities, and thus the artificial systems designed to mimic them, perform these functions in some respect. The limits to the ability to perform these basic functions are at the core of the bend/don’t break problem. Living things, as well as systems that imitate their functions, need inputs as a function of time. Living things can be starved of inputs and they’ll bend, i.e. adapt; their systems will shunt energy to other endeavors to save the energy they have for priority tasks - until the energy those systems consume for the purpose is no longer available, at which point, they expire.
Expendability Drives Progress
This fractal nature of expendability - the notion that everything, at every scale, can die, expire or simply outlive its usefulness - is fundamental to evolution and progress. Artificial systems humans create to achieve robustness to shock are unique to the sets of inputs around which they’re constructed. They can therefore become wholly inadequate when those inputs change. Even evolutionary biological systems can get wrecked by external shocks, but these systems are typically robust to these shocks at deeper levels, as they often have evolved structures that act as foils or firebreaks.
Self-Organized Criticality
Systems that emerge around large numbers of variables (complex systems) tend to exhibit something called self-organized criticality where the system organizes itself into a critical state, which collapses part if not all of the system. They do this by way of feedback loops, either positive, which augment effects in response to stimuli, or negative, which diminish them. We observe these phenomena, for example, when drought and other conditions persist, and forests become proverbial tinderboxes. We can visualize this process by considering a pile of rice grains we drop one at a time into a pile. The pile will grow and grow until a single marginal rice grain causes what looks like an avalanche. Specifically, when the angle of the slope gets beyond the angle of repose (the average angle of the slope) by a critical margin, it enters a critical state, which then corrects, roughly to the angle of repose. The negative feedback loop provided by the laws of physics stops the slide.
Stability Is Relative
Since systems are unique to their sets of inputs and their environments, when those inputs change, the system can become unstable. Instability in complex systems can produce outsized effects - sometimes known as butterfly effects. These are random tiny perturbations in systemic variables that get magnified through the system’s components. The classic definition is described as something akin to the flapping of a butterfly’s wings in Africa creating a hurricane on the other side of the world.
Butterfly effects are what’s behind the concept of black swan events. These are events borne of fractally-embedded randomness, that nobody could plan for or purposely insure against - because they’re created by such convoluted and unlikely paths of interaction that it is impossible to imagine their arriving with any degree of certainty. Because complex systems are so highly dependent on their initial sets of conditions that we don’t and can’t know, these effects can be of enormous magnitude.
Putting It All Together To Make Better Investments
Artificial systems such as governments, markets, corporations, or electoral systems tend to be created to solve specific sets of perceived problems. These problems then tend to morph over time, leaving the system to experience unintended inputs or to break down at structural weak points as systemic stress increases.
Knowing these breakdowns are more probable when systemic stress increases - stresses such as inflation, food and fertilizer shortages, fuel and water shortages across various geographies - confers a substantial advantage in itself, but we need to be able to predict where the slides will occur, not necessarily which rice grain, as it were, will trigger them. After all, real estate is fairly illiquid and therefore requires a longer investment horizon.
Conclusion: Seeing The Connections And Executing
Being able to reasonably predict market movements is a learnable skill, but it requires checking one’s ego at the door, being wrong a lot, and adjusting predictions as new information is revealed. Knowing and understanding how the big pieces move, and more importantly, how they can’t move, can confer an immeasurable advantage to one’s investing. Understanding that in a complex, adaptive system like the global economy or the climate, knowing how the biggest pieces can and can’t move can be like kryptonite for competitors. Sam Zell, the founder of Equity Group Investments, LLC, and one of the OG REIT creators, attributes his success to ‘dancing on the skeletons of other people’s mistakes.’ We are about to witness a cavalcade of other people’s mistakes - so we’d best have our dancing shoes on.
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