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Leverage Points, Systems & Paradigms - A Perspective of an Investment Analyst

This research paper is prepared by and is the property of H-o-l-o-c-e-n-e.com and is circulated for informational and educational purposes only.


 

The crises we face are systemic in nature. To overcome those crises we need to understand how systems work. To arrive at such an understanding we need to think systemically.

Ludwig Von Bertalanffy, General System Theory

 

According to Donella Meadows, who studied environmental limits to economic growth, "the leverage points are places within a complex system (a corporation, an economy, a living body, a city, an ecosystem) where a small shift in one thing can produce big changes in everything."


Introduction: Unbalanced Systems and Paradigm Shifts


In the past, because paradigm shift as a concept was so pervasive, I started assuming that any unstable system (economic or social) is likely to have a paradigm shift. As a believer in Hyman Minsky, I embraced the concept of "Stability is Destabilizing." (see my previous blog on unstable economic structures). I started looking for all the systems with a period of stability that showed order at the superficial level but were building poor economic/incentive/social/industry/financial structures. Whenever I identified an imbalanced system, I started assuming that it would begin to collapse, and we would see the reversal in the historical pattern. Now I believe that it is naive to think that such structural change would happen at the speed of thought or rate of narrative dissemination.



Search for the Theory of Structural Change


To understand the process of structural change, I extensively read Kuhn's 'The Structure of Scientific Revolutions.', North's 'Structure and Change in Economic History', and Santa Fe Institute's Essays on Dynamic Systems including Donella Meadows's 'System Thinking: a primer'. Kuhn emphasized the importance of identifying proponents who reinforce the current status quo and the anomalies that lead to new investigations. The final step is to locate the agents of change.





North's book applied Kuhn's theory into economics and came up with the concept of free-riders as agents of the status quo. The structure will not change unless and until very few free-riders are left, which will take years and years out. It could only happen at the institutional level or/and after an exogenous shock in the economic system.




"Leverage Points": The Points of Power



Now during my research, I not only focus on the existing trends but also the following "leverage points" (Donella Meadows) to monitor and understand the process of the structural change.


I will explain the leverage points with examples in the following section:


12. Numbers


Constants and Parameters are the bits of information (data)—a quarterly report categorized in this section. One entity's change in number does not say anything about the industry/system/company structure. Focusing on just numbers will not help you understand structural change. For example, following quarterly reporting of each entity in the following diagram is essential for monitoring the flows in the system. Still, it does not say anything about the change or nature of the system.



Source: H-o-l-o-c-e-n-e.com


11. Buffers


In chemistry and other fields, a big, stabilizing stock is known as a buffer. Bank's capital reserve ratio is a buffer to stabilize the banking system. Corporations keeping inventory is a buffer. They stabilize the system and reduce the volatility of the system. A system with poor buffers would experience significant volatility—for example, the inventory buffer before the pandemic and policy stimulants. Focusing on loan to deposits, reserve ratios, liquidity ratios, inventory ratios, leverage ratios, solvency ratios are tools to understand the system's strength against external shocks.


Example 1. Depletion of Inventory Buffer Causing Inflation in 2021.


Source: Federal Reserve Economic Data



10. Structures and Nodes of Intersection


Structures are usually the way nodes interact with each other. They are controlled by norms, rules, habits, behaviors, incentives, goals and mindsets. A sound operating system with reinforcing solid loops and buffers would be rigid and unlikely to change independently. Structures are usually not a strong leverage point, and the only leverage point is in proper design in the first place. After the structure is built, the leverage is only in understanding its limitations and bottlenecks.


Example. Current Structure of Payments Industry in the US



Source: H-o-l-o-c-e-n-e.com


For example, you could analyze how these players are generating returns per dollar equity. Unless and until there are no significant changes in the structure, the profitability would remain stable.





9. Delays - Feedback Loop's Delay vs Rates of System Changes



Delays are a critical determinant of system behavior. They are common causes of oscillations. A delay in a feedback process is necessarily relative to the rates of changes. Delays that are too short cause overreaction, "chasing the tail," oscillations amplified by the jumpiness of the response. Delays too long cause damped, sustained, or exploding oscillations, depending on how much too long. Overlong delays in a system with a threshold, a danger point, a range past where irreversible damage can occur cause overshoot and collapse.


  • Light Damped: Defined oscillations are observed, but the amplitude of oscillation is reduced gradually with time.

  • Critical Damping: The system returns to its equilibrium position in the shortest possible time without any oscillation.

  • Heavy Damping: The system returns to the equilibrium position very slowly, without any oscillation. Heavy damping occurs when the external forces (changes) exceed those of critical damping.


Source: H-o-l-o-c-e-n-e.com


For example, Buy now Pay Later disruptive businesses are seeing adaptive actions from the incumbents. If the adaptive players can re-establish their advantage, the change in the structure of the payments industry will be minimal. The oscillations are minimal in the market share because the rate of disruption is relatively low to the incumbent's advantage.


8. Reinforcing Loops:


A reinforcing loop is one in which an action produces a result that influences more of the same measure, thus resulting in growth or decline. Many other industries share a strong flywheel effect. The birth rate is an excellent example of a reinforcing loop in population growth.



7. Balancing Loop


A balancing loop attempts to move some current state (the way things are) to the desired shape (goal or objective) through some action (whatever is done to reach the goal). A competitor trying to change the state of an industry is a solid example of a balancing loop. Policy-making is the art of balancing the form of the system by countering reinforcing loops to reduce oscillations. I meant sound policymaking, not the ones which promote unbalancing reinforcement and discourage balancing.


Example: Square's goal (hypothetical) to disrupt the payment network.


You could monitor the flows (See Leverage Point 1) to validate whether Square is attempting to do so.


Observation 1. Reduction in the Cost (Traditional Network fees) and Maintenance of Gross Take Rate.



Observation 2. Expected Gross Payment Volumes.

Source: Company Reports


6. Information Asymmetry and System (Social) Costs


The information structure of the system is one of the most critical parts of a system. Missing information is one of the most common causes of system malfunction. Restoring missing information links could slowly and gradually heal the system. Accountability and transparency are two significant factors here.


Source: H-o-l-o-c-e-n-e.com


In the US, regulators banned merchants for charging surcharge for accepting credit cards. The decision to do shows a solid example of information asymmetry.



5. Rules - Incentives, Punishments, Constraints



The rules of the system define its scope, its boundaries, its degrees of freedom. They are high leverage points. Power over the rules is real power. Focus on the rule-makers (lobbyists or Chinese Communist Party) and are their incentives to understand the system's operation.


The US Government is also a rule-maker and competitor with the private sector in the US payments industry.

Source: H-o-l-o-c-e-n-e.com


Example: Fed Now

"The FedNow Service will facilitate end-to-end instant payment services for consumers and businesses, increase competition, and ensure equitable access to banks of all sizes nationwide. The Federal Reserve is uniquely positioned to build an instant payment infrastructure, given our long history of operating payment systems to promote a safe, efficient, and broadly accessible payment infrastructure.” —Governor Lael Brainard, The Future of RetailPayments in the United States (August 6, 2020)



4. Self-Organization: The Power to Add, Change or Evolve System Structure


The most incredible thing living systems and some social systems can do is change themselves utterly by creating whole new structures and behaviors. The ability to self-organize is the most potent form of system resilience. A system that can evolve can survive almost any change by changing itself. The catalyst for such reorganization is a failure or a shock. Life eventually finds a way.


Evolution, Innovation, Capitalism, Inequity (injustice), Creative Destruction, algorithms, etc., are all strong examples of self-organization.


3. Goals


It is one of the most vital leverage points. Suppose the goal is to bring more and more of the world under the control of one particular central planning system. In that case, everything further down the list, physical stocks and flows, feedback loops, information flows, even self-organizing behaviour, will be twisted to conform to that goal. Get to the bottom of the system's purpose, and you will be able to understand the reason for the system's existing structure.


Credit card networks incentivize the card-issuing banks to issue credit cards using their network by providing an interchange income. Banks' goal is to maximize shareholder profits. The structure and resilience of the credit card system are built upon the goal of maximizing shareholder value. The cheaper alternative (QR code), ACH, Fed-now will have to use other leverage points to change the behaviour of the issuing banks.


Source: H-o-l-o-c-e-n-e.com


2. Paradigms


Paradigms are the sources of systems. From them, shared social agreements about the nature of reality come system goals and information flows, feedbacks, stocks, flows, and everything else about systems. People who have managed to intervene in systems at the paradigm level have hit a leverage point that transforms systems. Gandhi, Einstein, Newton, Darwin, Carl Jung, and innovative companies such as Genentech, Moderna, and Amazon are strong examples.


So how do you identify potential paradigm shifts, or how do you change the paradigm? At the individual level, all it takes is a click in mind, a falling of scales from the eyes, a new way of seeing. At the social level, "Thomas Kuhn, who wrote the seminal book about the great paradigm shifts of science, has a lot to say about that. You keep pointing at the anomalies and failures in the old paradigm. You keep speaking and acting, loudly and with assurance, from the new one. You insert people with the new paradigm in places of public visibility and power. You don't waste time with reactionaries; rather, you work with active change agents and with the vast middle ground of open-minded people" (Donella Meadow). To identify potential paradigms, understand the system thoroughly (the root of the matter), look for anomalies, keep an open mind, and identify the agents of change or institutional change-makers.




Example: In the payment industry, if Square/Klarna/Stripe successfully transforms the payments industry, you will see the consequences. Value-Growth score by Morningstar assesses the old paradigm (old-growth metric), future estimates (by street) and market expectation (price multiples).

Another potential paradigm, Federal reserve targeting the social cost of the existing payments network.



Source: H-o-l-o-c-e-n-e.com and Morningstar



1. Transcending Paradigms


There are no cheap tickets to mastery. You have to work hard at it, "whether that means rigorously analyzing a system or rigorously casting off your own paradigms and throwing yourself into the humility of not-knowing. In the end, it seems that mastery has less to do with pushing leverage points than it does with strategically, profoundly, madly, letting go and dancing with the systems." (Donella Meadow)



 

"Without beginning, without end,

Without past, without future.

A halo of light surrounds the world of the law.

We forget one another, quiet and pure, altogether powerful and empty. ·

The emptiness is irradiated by the light of the heart and of heaven.

The water of the sea is smooth and mirrors the moon in its surface.

The clouds disappear in blue space; the mountains shine clear.

Consciousness reverts to contemplation; the moondisk rests alone.

The picture that belongs here is the one below."


The Secret of the Golden Flower




 

This disclaimer informs readers that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group or individual. You should not treat any opinion expressed in this article as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of an opinion.

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