Another excerpt from my book. Any feedback welcome! This bit is about derivatives:
What these examples [Great Depression, breakdown of Bretton Woods, the creation of the euro and 2008 crisis] show is that systems work for a while, but never endure. There is a constant need to reform, tinker and experiment. And with the world becoming ever more complex, institutions need a way to lock in some form of certainty. Derivatives can provide that. By far, the most common derivative is the interest rate swap, which allows one to switch from floating interest rates to a fixed interest rate (or vice versa). Your mortgage uses this!
When I say complexity, I mean the world has much become so much more complicated than ever before. A way to visualise this is the population of the world. It took over 200,000 years for the human population to reach one billion in 1804. It then took 120 years for two billion to be reached in 1927. It took 30 years for three billion to be reached in 1960, It took 14 years for four billion in 1974. It took 13 years to get to five billion, 12 years to get to 6 billion and 12 years to get to 7 billion in 2011. That exponential growth necessarily equates to much more complexity than we have ever seen.
It doesn’t stop there. When we get to this level of population, the possible combinations of people to form groups explodes. So with the current population the possible teams of five different people reaches :
or 140 billion trillion trillion trillion.
or a very very big number.
In that context the growth in financial activity over the past few decades may not seem so out of proportion. What matters is which bits have grown, and whether they will add or subtract risk.