Submitted by Charles Hugh Smith from Of Two Minds

Feedback, Unintended Consequences and Global Markets

We cannot know that unintended consequences will always be destructive. Neither models nor projections have accurate track records in predicting the future.



It seems an appropriate time to re-examine why our ability to predict the future of complex systems is so poor. A significant number of well-informed, smart people believe the Euro Experiment is unraveling in a positive feedback (i.e. self-reinforcing) death spiral.



Another significant number of people believe the market meltdown is overdone/oversold and global markets are set to rally despite the bad news. Their view is founded on negative feedback, i.e. forces that resist or counter the prevailing trend.



In the case of global markets, these forces include technical support/resistance, market intervention by The Powers That Be (TPTB) and the large number of people and instituions with stakes in the survival of the Status Quo: politicos, pension funds, wealthy Elites, government employees, and so on. These people stand to lose sufficient wealth and financial security to motivate them to "fight to the death," so to speak, to support the Status Quo.



All models of non-linear complex systems are crude because they attempt to model millions of interactions with a handful of variables. When it comes to global weather or global markets, our ability to predict non-linear complex systems with what amounts to mathematical tricks (algorithms, etc.) is proscribed by the fundamental limits of the tricks.



Projecting current trends is also an erratic and inaccurate method of prediction. The current trend may continue or it may weaken or reverse. "The Way of the Tao is reversal," but gaming life's propensity for reversal with contrarian thinking is not sure-fire, either.



If it was that easy to predict the future of markets, we'd all be millionaires.



Part of the intrinsic uncertainty of the future is visible in unintended consequences. The Federal Reserve, for example, predicted that lowering interest rates to zero and paying banks interest on their deposits at the Federal Reserve would rebuild bank reserves by slight-of-hand. Banks would then start lending to qualified borrowers, and the economy would recover strongly as a result.



They were wrong on every count. Zero interest rates (ZIRP) destroyed the returns of pension funds and savers, and drove investors into intrinsically risky "risk-on" trades such as stocks, long-term bonds (care to bet on what the interest rate will be in 5 years, 10 years or 20 years? Based on what crystal ball?) and various carry-trades. Paying interest to banks destroyed the incentive to lend and increased the incentives to speculate, knowing that "too big to fail"--the acme of moral hazard--meant the Treasury or Fed would bail out any bets that soured.



With margins so low and collateral so impaired, banks have had weak incentives to risk making loans and strong incentives to deposit money in the Fed to safely earn interest at zero risk.



With money supposedly "cheap" but scarce and dear in real life (other than mortgages backed by the Federal Government, another extension of moral hazard), then the reflation of assets the Fed predicted has failed to materialize except in the stock market, which has doubled under the fire-hose of liquidity provided by QE1, QE2, Operation Twist and various other monetary-inflation gambits.



Rather than organically boost risk assets via stronger demand in the real world, all these measures accomplished was to addict the markets to Central Bank injections of "free money."



Not only have all these consequences been unintended, they have also been perversely and highly destructive to the real economy, systemic stability and trust in the institutions of central states and banks. If you had set out to bleed the real economy, stability and trust in institutions, you could not have designed a more effective policy than that of the Fed and the European Central Bank (ECB).



There are no easy or painless ways to undo the unintended consequences, just as there are no easy or painless ways to "fix" what is unfixable, i.e. the euro, the U.S. financial system, the Chinese real estate bubble, etc.



All these forces are positive feedback, as each reinforces the others. Given this data, it seems obvious the global market systems will destabilize and disintegrate, and probably sooner than later.



But this overlooks the difficult-to-quantify forces of negative feedback, mostly based on the great number of people who have much more to lose if the Status Quo crumbles than they stand to gain. Thus artifice, slight-of-hand accounting, empty promises, money-printing and all sorts of other attempts to stabilize what is clearly destabilizing will be applied in full measure.



Just as we cannot predict the future, we cannot predict unintended consequences. We cannot assume they will all be destructive or negative; on occasion, policies "get lucky" and the unintended pathway has unexpectedly positive results.



Given what we know about failed fixes, it seems clear the global financial Status Quo will continue to destabilize if current policies continue. What we don't know is the precise pathway of that destabilization. We could summarize this uncertainty by saying that various feedbacks, positive and negative, will counter each other and feed back (self-reinforce) similar feedback loops, and which one has the upper hand at any one moment sets a trend that lasts until the other gains the upper hand or the two reach some sort of equilibrium that may or may not last for a time.



It's easy to model systems with a few variables, but the predictive track record of models is poor. It's also easy to project current trends, but the predictive track record of projecting current trends is also poor.



The best we can do, it seems, is to be alert to both existing positive and negative feedbacks, and be alert to new feedbacks which could fundamentally alter the system.