first majestic silver

When Systems Fail . . . .

October 30, 2000

A system is more than the sum of its components.

One can place together all the parts that go into the construction of a motor vehicle, but that would not be a car, or a truck, but essentially a pile of junk. The components have to be fitted together in specific ways, according to their function and interaction with each other, before it becomes something that is both useful and deserving of care and regular polish.

But it is not how to build systems that is the theme here, but what happens when these systems are subjected to increasing load and/or decreasing care and maintenance.

When systems are subjected to load, some degree of degradation in their performance results. The degree of degradation is a function of the loading that is imposed, in terms of the design or operational parameters of the system, as well as the degree of cumulative and permanent degradation that has taken place as a result of wear and tear. The latter can be rectified to some degree by timely and adequate preventative maintenance, but if this is not done both regularly and properly, the ability of the system to function under load is impaired to a greater degree.

The main objective is to discuss the failure of financial and market systems, but for the time being we will remain with motor vehicles as these serve as good analogies for what is to be said about markets.

Systems and system loading
The theme that we will deal with is that complex systems, such as motor vehicles – and markets – fail asymptotically under load.

The more immediate the effect of the load and the greater the degree to which the load exceeds normal operating parameters and limits, the more sudden and the catastrophic the effects of the failure.

However, system loading can be of two kinds. The first type is the actual and immediate load imposed on the system, such as increasing the physical load being carried by a truck, or asking it to climb gradients under load that it was not properly designed to cope with.

The second kind is less immediate and with a gradual, if slowly accelerating, debilitating effect over the longer term. Not doing proper maintenance is an example of this more subtle kind of operating load. Using the vehicle over terrain that it was not designed for, or running it without adequate lubrication or coolant could be other examples. However, if the lubricant or coolant falls below a certain danger level, the load becomes critical and damage is both certain and catastrophic.

For complex systems to operate satisfactorily for a long time, care should therefore be taken not to overload the system nor to neglect maintenance and operating instructions.

Systems fail asymptotically
If one were to load a truck, there will at first be negligible degradation of its performance. Then, as the size of the load is increased to the truck's capacity, there will be a gradual worsening in its performance, but still within acceptable limits. This trend continues even when the load is increased to above its rated capacity – at first the degree of degradation follows the earlier gradient, with relatively small losses in performance for what could be quite large increases in the load, even over full rated capacity.

An observer, or user, who has been following this trend, will do a mental extrapolation and come to the conclusion that one can increase the load even further without impairing performance to the degree where it would no longer be acceptable.

Then – surprise, surprise! – as this assumption is turned into action, the vehicle suddenly turns into a disaster case and in very quick fashion becomes completely unserviceable.

It is this rapid collapse that follows what seems to be a rather small increase in the load, which can be called asymptotic failure.

The diagram illustrates the principle.

As long as the load remains below some critical level, the increase in the degradation is gradual, even if not linear, and the impression is formed that the system is robust and can absorb a much heavier load without becoming unserviceable, or even losing performance to what would be considered an unacceptable level.

Then, as shown by curve A, when the load passes the critical level, the break down in performance is quite sudden, in relative terms, and spectacular.

In the case of a truck that suffers from poor maintenance, the final phase of steeply decreasing performance does not happen in a day or two. The incidence of part failures increases as the load is increased, until too many parts fail in a relatively short period for the truck to be really usable without major and extensive repairs and the replacement of suspect parts.

Thus, if the sequence of increased overloading and subsequent part failures, followed by running repairs, proceeds within what could be considered reasonable parameters, the break down in the truck's performance happens according to curve A – where the end result is a truck that needs a major overhaul before it is really fit to be used again.

What is different from this neglect occurs when parts fail and, in order to prevent a repeat of that failure, the replacement or repaired part is artificially strengthened to cope with over-capacity loads. By doing thus, say, by using more robust axles, the brakes and suspension now come under greater strain and they start to fail. Once stronger brakes and strengthened suspension have been fitted, the truck can carry an even heavier load, but now the transmission begins to give problems and real heavy duty tires have to be fitted. Fit the tires an solve the transmission problem, and the engine is being overtaxed under the still increasing load and performance again suffers until the engine is seen to.

Eventually, this forced method of maintenance reaches a level where individual parts of the system have been buttressed way beyond their design parameters and yet, for the time being, everyone is quite happy with the result – the truck keeps on performing like a giant, a star trooper! Except, of course, for the frequent failure of various parts that are then repaired or replaced in order to make the truck even more robust.

But there is a flaw in this method – a flaw that is revealed when the truck, now rapidly proceeding along curve B in the diagram, reaches a critical level.

What is forgotten in the above reasoning, is that a system is a cohesive structure of parts. The parts were not thrown together haphazardly, but were designed to mesh with each other in terms of certain design parameters. This kind of intensive, forced maintenance, in which each part that fails is seen to and strengthened in isolation, disregards the original parameters and thus also ignores the relationship between parts. What happens now when the critical point in the curve is approached, is not that another part fails, but that the truck itself fails – as a truck. The parts have lost their cohesiveness, the load now exceeds the strength of the links that keeps the parts together in a way that transforms a lot of essentially scrap metal into a thing called a truck.

The failure that happens now is not like the one at the end of route A, where the truck ends up in need of a major overhaul. No, when route B is followed, the end result is something that is ready for the scrap heap.

And it will have to be taken there as a load on another truck. Completely useless for its designed purpose. Even the parts have no further use as they have been too abused and too much modified.

That is why line B increases steeply without end – the collapse of the system is for all practical purposes complete.

It follows that the amount of manipulation of the system, the degree to which elements of the system have been modified and transformed in order to keep the system operating "over spec", and in violation of its natural parameters, will determine how far to the right of curve A the system can be forced before the final critical point is reached and the degradation shoots skyward.

And thus how steep and complete and catastrophic the eventual collapse will be.

Financial markets
So what has over-loaded trucks to do with financial markets?

What applies to trucks as complex systems applies to other complex systems as well – even though the nature of the "loads" may differ. Basically, the above says that for systems to remain stable, they have to be operated within "spec" and receive adequate attention in the form of maintenance.

For any system there are certain parameters that define "normal" operating limits. Like a motor vehicle, or any other complex system, a financial system should be kept within normal operating range, and care must be taken to monitor the situation and to perform any "preventative maintenance" that might be required; correcting or repairing parts of the system where problems develop that are inconsistent with the correct and proper functioning of those elements within the integrated system – in other words, parts whose performance moves out of "spec" to have a negative impact on overall performance.

The first requirement, therefore is to be able to monitor the system – to have an idea of how it is working. In a vehicle this role is performed by the various gauges on the instrument panel as well as such measures as taking the tire pressure. In an economy, the various statistics and their interpretation by economists perform the same function.

A second requirement is to know what are the standard "specs", or operating parameters . In other words, what are the optimal ranges for the various statistics, not only in isolation but also in relation to each other. What are their tolerances and what is the nature of the preventative maintenance that has to be done to ensure compliance with these parameters. Then, too, one should know when a part has reached the point of actually failing, so that urgent "running repairs" can be made before the problem gets acute and spreads to other parts of the system.

This knowledge of course come from experience, supplemented by theoretical analysis. Economists and other analysts by now have a vast data bank of what has happened in the past and which "out of spec" trends and developments have caused severe problems to the economy. And, since the underlying nature of the economy does not really change, what has been learnt from the past still applies in the present. The basic rules of the free market system and the capitalist economy have not changed much over the past 100 years and more – with changes being mostly of degree, rarely of kind, if any such changes have in fact been identified and recorded.

How would the analogy of a truck that is being abused apply to an economy?
In general terms, what was done to the truck can be described as either neglect or rape, if such a term can be used to convey extreme abuse.

Neglect, over time, results in failure along curve A, which can perhaps be likened to a recession – a time of healing during which the harmful effects due to parameters that have moved out of "spec" can be dissipated and corrected, thus preparing the economy for new and sound growth.

Positive abuse occurs when there is actual intervention of some kind or other to "force" the economy and the markets to perform at some desirable level yet way out of "spec" manner. In that case, if the intervention and manipulation lasts long enough, the economy will end up along line B in what is no longer a mere recession, but a full depression.

What would constitute the kind of abuse that would lead to curve B?

There are different kinds of abuse, some of which are discussed below.

The first could be classed as "active neglect" – being aware of some aberration in the economy that is likely to cause trouble in the future, but not doing anything to solve the problem since it is believed the corrective action would be counter-productive elsewhere.

This in itself implies that there is a private agenda, as a harmonious and healthy economy requires all its parts to operate within certain known tolerances from equally well-proven optimal levels and relationships. If this agenda requires that one part be neglected so that another part or parts of the economy can continue to operate "out of spec", it is a more severe case of abuse than the benign neglect that results mostly through ignorance of what is really happening.

A far worse case of abuse occurs when authorities, and others, actively intervene in or manipulate the markets and the economy into performing way out of "spec" in order to achieve short term goals. The role of the authorities in this respect can perhaps also be explained at the hand of the truck analogy.

For a truck to operate two ingredients are essential – fuel in the gas tank and someone to keep a foot on the accelerator. In the economy one could see equivalents to these in the money supply and in interest rates. Money supply refers to the amount of fuel that is available, while interest rates are the accelerator pedal that determines how much of that money is put to work.

If either of these two factors move too far from the ideal, as measured against the ruling parameters of a healthy economy, then sooner or later the trend will begin to move along curve B, which, over time, will ensure that more than just the wheels come off.

In this sense, the damage is not always apparent after a week, a month or even perhaps a year or two. An economy has a certain inertia and it takes time for neglect or even active abuse to one or a few parts for the system to deteriorate to where other parts are being seriously affected – thus placing the whole system at risk.

For example, assume that for an economy to keep on functioning according to and within design parameters, there has to be a balance between imports and exports – not from day to day or week to week, or even year to year. But, over time, a consistent bias in favour of either too many imports or too much exports would introduce the kind of over-capacity loading of the system, discussed above, that constitutes more than just negligence, but becomes real abuse of the system.

Similarly, sustained inflation in the value of parts of the economy is sooner or later going to introduce disruptive forces that will impede or even prevent normal functioning of the economy. Another neglected or perhaps even abused factor could be the amount of debt consumers in the economy can carry, which is largely determined by what they earn, given a stable interest environment. Consumer debt can not (be allowed to?) increase at a higher rate than income without, again sooner or later, causing severe problems.

And I am sure readers can think of half a dozen or more examples.

A second form of abuse that goes hand in hand with active rape of the system is when the monitoring or reporting system is modified to present a different picture of the true state of affairs. In a truck this could be as innocent as regularly winding down the speedo to save costs through less frequent maintenance. Or it could be that the governor is tied down or otherwise made inoperable, so that higher than safe speeds can be maintained. Or any of a number of other ingenious modifications to the innards of the truck to cause the situation to appear within operating limits when this is not really so.

The economic equivalent of such action needs no further elaboration as in fact too many examples of distorted reporting come to mind quite easily.

Another way of disguising the true state of affairs is to give the truck a new coat of paint, to chrome a few pieces and then ensure that it remains gleaming and spotlessly clean. In an economy, the equivalent to this would be the creation of a public appearance of good economic health by the media as well as by official pronouncements.

If the media were to remain true to its calling of reporting the world as it really is, and not become slaves of another agenda or perhaps reach the point where it comes to accept its own propaganda – actually believing that the world really will become as it is reported to be, to paraphrase Marshall McCluhan – the media could act as a powerful 'governor' that helps to keeps the system within its operating range.

When the media fails to live up to its self-proclaimed role, it paints a pretty picture that is far removed from reality – one that in time will damage both the popular image of the media and its profitability far more than they can imagine.

Here, too, there is no need to quote examples of the painting and chroming going on.

The effect on the economy
As before, these factors too can be separated into either the result of benign neglect or just ignorance, or as the result of deliberate interference in and active manipulation of parts of the economy in pursuit of short or medium term goals that have relatively little to do with the maintenance of economic health.

Within reason, once it becomes apparent that because of such interference, through inappropriate policies or any other measures, problems begin to manifest themselves in the economy, the situation can still be reversed. For example, when a truck is going too fast for safety, judicious use of the brakes and less pressure on the accelerator can bring matters under control. However, if the driver deems the high speed to be reasonable in view of the wide, straight road, he should keep his eyes wide open – coming too fast onto a sudden steep turn in the road will end in the truck going out of control and catastrophe.

The same is true of an economy.

As was the case for the truck, if the solution to failing elements in the economy is to persist with crisis repairs and the strengthening of the failing part, through whatever legitimate or clandestine means that are available and that will do the job, then the die is cast. The economy, like the truck, is steadily moving off curve A and onto curve B.

In due course the problems begin to take on an existence of their own and begin to grow organically. Then it will be too late – like a speeding truck on a steep, twisting gradient with brakes that are starting to fail.

Then it is just a matter of time before the critical point is reached and something – perhaps something quite minor – happens to send the system plunging into a spectacular if very humiliating, painful and expensive catastrophe.

No longer individual parts that fail, but the collapse of the whole system itself as the normal interaction and cohesiveness between individual elements break down.

The gold market, too, functions as a system. It too has been subjected to imbalances that have been exploited in a way that is not natural for the system.

In fact, if reports are accurate, the gold market system is the extreme example from the modern era of a market system that has been subjected to immense manipulation and interference. Then the truck as analogy breaks down – pun intended! – and one should begin to consider pressure cookers or submarines, entities that have been purposefully designed to absorb tremendous pressures. Yet, even these explode or collapse – as the case might be, when pressure mounts to way beyond the design parameters.

Here the situation is not one of gradually escalating failures over a period of days, weeks or even months until the whole system succumbs to the deterioration. No, as pressure mounts to the level where something really has to give, something minor does. And the effects are immediate, irreversible and catastrophic.

When that perhaps quite minor thing happens – a sealing ring that develops a small but rapidly expanding leak or a welded seam gives way – the total collapse is immediate and spectacular, provided, of course, one can hypothetically observe it from a remote distance and is not part and parcel of the event.

And, as with pressure cookers and submarines, there is no predicting when it will occur or what will trigger the event. There might be a lot of creaking going on for some time, to warn that the crisis is imminent, but then, too, the creaking could well last longer than anyone expects.

With the presidential election only days away, it is inadvisable to risk any forecasts of what is likely to happen and when. There are nevertheless signs that intervention in the equity markets and perhaps even in the economy at large has reached a crescendo in recent weeks. Efforts to keep Wall Street afloat are more blatant than perhaps ever before – lots of elephant tracks around, to refer to an earlier theme. It would also seem that the bond market is reacting to more than just a flight to quality.

And the dollar? Can it be real?

At the same time, widespread references to a mounting credit crunch show that the health of the economy has been undermined for some time and to a degree where problems could be approaching crisis proportions.

Yet the monitoring system still reports that all is well. That there are no problems that require urgent attention and that the problems that are identified will sort themselves out in due course, with little or no corrective action required.

It is not too difficult to imagine having a conversation with the owners of trucks A and B, respectively, to listen to their explanations and rationalisations for what they are doing.

What is real bothersome is that what one perceives to be happening in the markets and in the economy, and what one hears people who should be in the know say, sound far more like the owner of truck B than the owner of truck A.

Minting of gold in the U.S. stopped in 1933, during the Great Depression.
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