Finance and computers: an analogy

A computer takes digital data and transforms it in fairly basic ways. Adding, subtracting, logical statements etc.

Computers are powerful tools because we can make them perform more complex tasks than these basic functions by building new layers of abstraction on top of these basic processes.

Machine code can be used to make a compiler for the C programming language, which can in turn be used to make an operating system, on top of which can run applications, which can be used in ever more complex and elaborate ways.

Abstraction and "higher order" properties are important in computing, but when the same ideas are applied to finance things go all gooey.

The basic unit of economic interaction is not a bit or a logic gate; it is a human being, an absurdly complicated thing, and one that we don't fully understand.

In computing, logic gates and machine code are fairly simple. Because they are simple and well understood, we can build a layer of abstraction on top of them and rely on them to function correctly whilst we pursue higher order things (like writing and reading blogs).

This is what SF writer Iain Banks calls the "dependency principle" - complex software is based on a simpler layer beneath it, which is in turn based on an even simpler layer beneath it, until you get out of software and into the bare metal.

In the recent economic troubles - the credit crunch caused by the insidious spread of bad mortgage debt and the fact that banks now don't know how much these assets are worth (if anything) - can be thought of in similar terms to the structure of software.

A layer of abstraction is based on a simpler substrate: derivatives that are based on the risk of a given mortgage defaulting.

The difference between finance and computers is the layer beneath the abstraction isn't straightforward and predictable.