The economy is getting more complex. We all know that. Recently we have measured the rate of increase of complexity of the US economy using macro-economical indicators collected over a period of four years. The plot above – see orange curve – shows the result. A clear upward trend, punctuated by oscillations, showing an approximate increase of about 12% per year – close to 50% in 4 years. 

At this pace, the US economy doubles in complexity every 8 years. But in practice, what does this increase in complexity  translate to? Higher complexity implies more difficulty in management terms and, therefore, increased risk exposure (providing, of course, that the management resources and techniques remain unchanged). But if management resources remain the same – imagine a growing company run by a constant number of managers – the system will globally become less robust. The same happens to the economy.

An increase in complexity means that the economy is becoming more turbulent and less predictable. The critical complexity of the US economy is also increasing – see top curve in the above figure – but the relative distance between the complexity and this upper limit is decreasing. In other words, the robustness of the US economy is globally decreasing, see plot below.

There are of course cycles and oscillations, as the system is highly non-stationary but, because of the Second Law of Thermodynamics – which guarantees increases of entropy (a fundamental ingredient in our measure of complexity) – the overall trend is and will be towards states of higher complexity and lower robustness. In an economy of such characteristics, it is of paramount importance to take a different look at risk and risk rating.

Current risk rating models – these are seen as one of the main causes of the subprime crisis – neglect complexity altogether. A complexity-based look at risk, such as the one advocated by Ontonix allows a global and holistic look at the structure of risk and of its main causes. Risk stems from excessive complexity and the inability to deal with this increase. In an economy of increasing complexity and decreasing robustness (and natural resources!), it is no longer possible to resort to risk and pricing models erroneously based on the bell-curve and assumptions of normality. Current strategies of risk management, such as the Modent Portfolio Theory or the Black-Scholes option pricing models are indeed based on the bell-curve idea and are likely to fail at the worst possible time. And indeed they do.

Via Ontonix