The study sought to fill in the gap in between small ethnographic studies and large-scale surveys. The former cannot capture how lives change over time and the latter fail to capture the nuances of individuals. Portfolios is filled with revelations that came about solely due to their method.

While reading Portfolios, I couldn’t help but feel that ICT4D suffers from the same gap as microfinance. On the one hand, there are plenty of small, short-term studies of people’s interaction and relationship with technology (e.g. Chipchase), and on the other are large-scale surveys of national ICT usage (e.g. RIA).

So, what would an ICT diary project look like? Luckily, the authors of Portfolios provided an appendix detailing their methodology and processes. Some key points:

• Conceptualizing as diaries is useful because tracking in (near) real-time avoided memory loss (who really remembers how they used a cell phone two months ago?). It also helps to capture the relationship between money (or ICTs) and time. Looking at the flows was important for the Portfolios project because if they had simply surveyed irregularly they would have thought that large assets, which were the majority of the wealth for the subjects, were important; instead, it was the margin – small loans, daily wages – that provided most of the activity about their welfare.
• Given the deeply personal nature of both finances and communication, a long-term relationship between researcher and subject is necessary to develop trust. The Portfolios researchers were close in socioeconomic characteristics to their subjects to minimize the barriers. Even then, subjects were not always forthcoming and the researchers needed to really probe to discover all the financial instruments used. The trust issue also meant that the bimonthly visits needed to be conversational, not interviews. However, they write that “the strength of the diaries approach is that it can, over time, break down much of this reticence and confusion.”
• The effort wasn’t meant to be statistically representative, but they did choose families in low, middle and high levels of poverty.
• The information they gathered did not match their preconceived categories, so the researchers had to iterate towards perfection.
• There is the possibility that merely observing the financial lives of the subjects changed their behavior (a Heisenberg effect).

For an ICT diary project, there would obviously be differences. I imagine that ICTs are used more frequently and with less thought than major financial transactions, so there will definitely be uses that are forgotten or not mentioned to the interviewer. This problem could be minimized by using software to track usage, but capturing this quantitative data would need to be done very carefully to avoid privacy implications. A solid framework for usage would need to be utilized to make sense of various uses of ICTs and the behavioral evolution that I would expect to see in a year’s time.

Discussing this at Mobile Tech for Social Change Cape Town on Saturday, it was pointed out that the ISPs and telcos have much of this data, but getting them to share it would be next to impossible. Certainly looking at that would be useful, but the ICT diaries would be another way, and perhaps a better one, because the discussions with the participants would provide insights into their relationship (perceived and real) with technology.

If development practitioners are going to build ICT solutions for the poor, they must understand how they use technology. That understanding is certainly aided by the existing studies, but the gap in the middle seems to be where much of the insights will be found. Following ICT usage for a year would allow researchers to explore the evolving behavior that comes from both internal and external changes.

[Image from Kiwanja's mobile gallery.]

The critique which most resonated with me was the focus on short-term profits that leads to risky behavior and long-term failure. For example, starting three years ago, a private investor named Harry Markopolos repeatedly tried to sound the alarm about the Madoff Ponzi scheme, writing and speaking with S.E.C. regulators who did nothing to stop the enormous fraud. The reason no one stopped Madoff and the reason we are in this crisis is because all involved have misaligned interests.

OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The tyranny of the short-term manifests in credit rating agencies who make money off the firms they are supposed to rate honestly. It shows up in the S.E.C. where regulators seek good relationships with financial institutions in order to receive higher paying jobs in the private sector. It’s on display with bank executives who will be forced out if they don’t make short-term profits.

This is something about which I’ve worried for a while: how do we imbue our market-driven firms with long-term thinking? Quarterly earnings reports, expected to be better than 3 months before, seem like a good idea for shareholder accountability, but it also forces firms to make short-term decisions that may harm their long-term interests.

Lewis and Einhorn are dumbstruck that 18 months into this situation, next to nothing has been done to solve these structural problems. Although they have their disagreements with how Treasury Secretary Paulson is managing the problems (they advocate letting the banks fail), the more important, long-term problems haven’t been addressed.

Their solutions are:

1. Stop making regulatory decisions with long-term consequences in fear of their short-term effects
2. End the official status of the rating agencies – either privatize the rating or do it publicly
3. Regulate financial innovations like credit default swaps (see Bookstaber’s book for their danger)
4. Place capital requirements on banks or break up banks into parts that are small enough to fail
5. Don’t allow S.E.C. officials to work on Wall Street, but encourage the flow in the opposite direction

I’m glad sensible, structural proposals are being put forth and hope Obama and the incoming Congress heed them.

Bookstaber’s central argument is that financial innovation – Wall Street geniuses creating new products – increases the complexity of the market to an extent that it is impossible to understand and manage, leading to the dramatic events of the past twenty years. These are dramas Bookstaber saw first-hand, and by his own admission, helped engineer as an MIT PhD working on the cutting edge of finance.

The book is both history and theory, though being far from a finance expert (I often relied on my Dad’s explanations over the past two days), the theory was far more interesting and will be the topic of this post.

The history, though, is also compelling. It chronicles the numerous catastrophes of the past 25 years including 1987′s crash, the Internet bubble and Long Term Capital Management’s implosion. Bookstaber explains how these disasters were not due to outside forces (say, an oil shock), but due to the financial system itself. As investment strategies became increasingly sophisticated, aided by top mathematical models and cutting-edge technology, failure increased. The opposite should have been true: Nobel Prize winning academics were devising financial products and investment strategies to more fully quantify the market. However, fundamental, endogenous differences prove to be insurmountable barriers to financial perfection. The reasons are two-fold: the normality of accidents and the limits of human knowledge.

Complexity, Tight Coupling and Normal Accidents

I first encountered Charles Perrow’s book, Normal Accidents, while reading about another interest of mine: climbing. In his impressive book, Deep Survival, Laurence Gonzalez draws heavily upon Perrow’s insights to explain why accidents in outdoor sports are not only likely, they are standard. The idea showed up again when studying nuclear reactors in my Science, Technology and the Global Arena course last semester. A theory that applies equally well to climbing Mt. Hood, Three Mile Island and the fall of Long Term Capital Management should clearly be required reading, but many remain unfamiliar with Perrow’s brainchild, now decades old.

A normal accident is one which unavoidable due to the structure of the system. Systems which lead to normal accidents are complex and tightly coupled. Complex systems are nonlinear structures where actions in one area cause events among the system. No individual completely understands a complex system, whether it be a space shuttle or modern market, and no amount of testing will ever uncover every possible outcome. By itself, a complex system isn’t prone to catastrophic accidents; the problem comes when the system is also tightly-coupled, meaning processes are time-dependent. If a book isn’t reshelved at a library immediately, no serious problem emerges because a library isn’t tighly-coupled. If, however, a nuclear reactor safeguard doesn’t kick in immediately, a cascade of errors will quickly lead to disaster. There is little slack in a tightly-coupled system, so exactness is important.

Today’s financial markets are both complex and tightly-coupled. They are complex, in large part, because banks hold leverage around the world – meaning that problems in Japan can quickly reach Brazil, even if no direct economic connection exists. “The tight coupling in financial markets comes from the nonstop information flow and unquenchable demand for instant liqudity.” The result is the presence of normal accidents of historic proportions. The history of financial markets also shows this: the famous Dutch tulip mania only reached manic proportions when someone had the bright idea of creating forward contracts, so traders could “buy” tulips that didn’t even exist and proceed to trade those pieces of paper on the expectation of a flower crop.

Financial markets, complex and tightly-coupled, are bound to have failures like the one crippling the economy today. The easy answer, resonating especially hard today, is to regulate the industry. Yet, the most common forms of regulation only add to complexity, and thus accidents. Bookstaber argues that regulation should seek to reduce complexity in the first place, rather than try to control it after the fact.

The Limits of Knowledge

The second theoretical discussion, and where I think Bookstaber is at his strongest, is in his discussion of the limits of human knowledge. In it, he channels some of Nassim Nicholas Taleb‘s “black swan” proposition, but curiously fails to mention his fellow quant-turned-critic. Bookstaber takes three decently well-known concepts and molds what I found to be a spectacular chapter about epistomology (can epistomology be spectacular?).

The first of those is Kurt Godel’s proof that nothing can be proven invariably. The primary example are the self-referential statements known as the Liar Paradox. “This statement is a lie” cannot be true because doing so would contradict it. Godel’s point that not everything followed a logical path was magnified by Wener Heisenberg’s famous Uncertainty Principle which showed that by simply observing a particle, it was changed. The result was a recognition that it was impossible to objectively know something precisely, and the harder we tried, the more variance resulted. The ability to know the future disappeared because we could not accurately know the past or present. Bookstaber writes,

“This metaphor extens neatly into the world of financial markets. In the purely mechanistic universe of classical physics, we could apply Newtonian laws to project the future course of nature, if only we knew the location and velocity of every particle. In the world of finance, the elementary particples are the financial assets. In a purely mechanistic financial world, if we knew the position each investor has in each asset and the ability and willingness of liquidity providers to take on those assets in the event of a forced liquidation, we would be able to understand the market’s vulnerability… Practically, it wouldn’t work. Just as the atomic world turned out to be more complex than Laplece [Heisenberg's predecessor] conceived, the financial world may be similarly comlex and not reducible to a simple causality.”

The reasons are manifold, but rest primarily on the fact that traders do not exist in a vacuum and do not hold perfect information. Transparency increases result in liquidity decreases – as we seek to observe (by increasing transparency), we change the market (by altering the supply of liquidity).

The final piece of Bookstaber’s argument for accepting human ignorance is the work of Edward Lorenz, commonly known as the “butterfly effect.” So-called because a hypothetical flap of a butterfly’s wings may be magnified over weeks to effect the weather across the globe, it comes out of the recognition that minuscule perturbations can have astronomic repercussions. Indeed, because because Heisenberg showed that we cannot measure without some error, “for many dynamic systems our forecast errors will grow to the point that even an approximation will be out of our hands.” As Kevin Kelly pointed out, increased understanding only leads to increased awareness of ignorance.

Coarse Behavior

Then what about the billions of dollars run through advanced algorithmic trading schemes? How should an investment firm structure to avoid normal accidents? Bookstaber is weakest when it comes to recommendations (possibly because he is not a policy wonk, possibly because he runs a hedge fund of his own), but he does include some interesting discussion of the value of coars behavior.

Looking to biology, Bookstaber sees the cockroach as the ideal risk-manager; after all, it has survived tectonic changes in environment and continues to outwit human predators. The reason is because its defense mechanism consists of the rather unsophisticated rule: if a puff of air is detected by its fiber nervous system, it scurries. The puffs may or may not signal an approaching predator, but the cockroach runs anyways. As Bookstaber writes, “This risk-management structure is extremely coarse; it ignores a wide set of information about the environment – visual and olfactory cues, for example – that one would think an optimal risk management system would take into account.” That is, the cockroach filters out all but the essential, if at times inaccurate, indicator of doom. As Clay Shirky said at this year’s Web 2.0 Expo, it’s not information overload, it’s filter failure.

Compare this to animals like the oddly named furu, a finely-tuned product of Darwinian selection – specialized in almost every way for its environment. The furu, though, suffered near extinction when an alien species was introduced to its lake. The parallels are clever: highly specialized financial models and strategies cannot last in a complex, tightly-coupled market where change comes fast and furious. Although fine-tuning may yield short-term payoff, the inevitable result (2-3 years in Bookstaber’s observation) is extinction.

Instead, he advocates an investment strategy configured for the unknown. In addition, the strategist seeking to avoid the fate of the book cover’s Icarus should simplify organizational complexity and introduce slack when possible by decoupling processes. The take-aways are many, but as endogenous pressures continue to wreack havoc on the market, Bookstaber provides a powerful argument against increased innovation which only introduces more normal accidents.

If you liked The Black Swan or Fooled by Randomness, or want to better understand today’s economy, I cannot recommend this book enough.