Barney Frank, discussing the profound changes in how financial markets operate today:

“But as Marx says, in this case accurately, changes in quantity become changes in quality. And that’s what we have to look at.”

Actually, it was Hegel who first came up with the idea that as something increases in quantity, it progresses to a point at which a phase transition occurs, and a new thing is born. But Marx and Engels borrowed a lot from Hegel, and they loved the quantity-quality formulation. One example cited in “Das Kapital” referred to the metamorphosis that occurs when an individual accumulates enough money to become, well, a capitalist! A different beast, indeed, as anyone who has lately been comparing the take-home pay of hedge fund managers to UAW members could tell you.

For Frank, in the context of the hearing on “Systemic Risks in the Financial System” he chaired on Tuesday, the point appeared to be that the proliferation of financial innovation in “structured finance” that has transpired over the past decade has confronted would-be regulators with just such a strange new thing. If the turmoil in the credit markets over the summer made one thing clear, it is that no one really knows what’s going on. The quantity of complexity, one could say, has made its phase transition into an age of uncertainty.

Love him or hate him, Frank chairs a heck of a hearing. The panel of witnesses testifying included Richard Bookstaber, a former hedge fund manager and author of “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation”; Duke Law professor Steven L. Schwarcz; Robert Kuttner, the editor of the American Prospect; and Alex Pollock, a fellow at the American Enterprise Institute. Along with Karl Marx, the ancient Roman Cincinnatus and the writer Washington Irving also made guest appearances.

Kuttner and Pollock both gave smart, historically grounded but somewhat predictable presentations. Kuttner is a strong advocate of more regulation; Pollock believes in less. Both were fed fat, friendly questions by representatives who shared their ideological predispositions and both acquitted themselves well. Schwarcz was fairly technical, and his testimony seemed to sail over the head of some of his listeners.

But Bookstaber, fresh from an extended tenure in the belly of the beast, stole the show.

For Bookstaber, there are two critical issues: the growing complexity of the entire system, and the speed with which events can cascade, given the tight linkages that exist between both markets and the players within those markets. “The tendency for markets to move rapidly into a crisis mode with little time or opportunity to intervene” is a function, said Bookstaber, of “tight coupling,” a term borrowed from the field of engineering.

A tightly coupled system is one in which a change in one constituent part quickly propagates to everything that it is connected to. In other words, break one little piece, and a space shuttle crashes or a nuclear plant shuts down.

Bookstaber’s testimony closely parallels the argument presented in the paper “What Happened to the Quants in August 2007?” discussed here yesterday. A highly leveraged hedge fund — one that is using lots of borrowed money to make its bets — bets wrong and suddenly has to pony up cash for margin calls. The only way to do so is to sell whatever it can, but the downward pressure exerted on those holdings sets off a ripple effect in all the other funds that are operating according to the same strategy. And the popularity of computer-mediated trading means it all happens so quickly that no human can do anything to stop it.

“In financial markets, tight coupling can come from computer-driven strategies,. But more commonly tight coupling comes from the effects of leverage.

When things go badly for a very highly levered fund, its collateral can drop to the point that its lenders can force it to liquidate assets. This liquidation can lead to a drop in prices, which leads to the collateral dropping even more and therefore forcing more sales and more liquidation. And the result is a downward cycle, which is the sort of thing that we saw with the demise of Long Term Capital Management in 1998, and it also is what we saw with a number of hedge funds in the recent past.

And it can get even worse than that. Because just like complexity, leverage can lead to surprising linkages between markets. In fact, high leverage in one market can end up devastating another unrelated and perfectly healthy market. This happens because when a market’s under stress it becomes illiquid and fund managers must look to other markets to liquidate. Basically, if you can’t sell what you want to you sell what you can.”

The panelists discussed a wide spectrum of regulatory options with potential to deal with the challenges posed by financial innovation. Where that effort heads will be affected by where the economy goes in the next year and who comes out triumphant in the 2008 elections. But as an initial first step, one that you might think sensible people of both parties could agree on, it’s hard to beat Bookstaber’s proposal: Let’s find out what is going on, first, and only then make decisions about what to do next.

As it stands now we don’t know the extent of leverage individual hedge funds operate under or who their “counterparties” are — the institutions with whom they are so avidly trading credit derivatives and all kinds of other funky new financial instruments. We are thus unable to predict how the collapse of one fund or sector might spread through the rest of the system. There is an incredible absence of transparency as to how markets currently operate, which makes it impossible to evaluate risk or proactively head off problems.

The more conservative panelists and legislators were fond of repeating the point that no matter what we do, 10 years from now there’s going to be another problem. Their point seemed to be, why bother doing anything, if that’s the case? But just because all future problems can’t be solved in the present doesn’t negate the possibility that we might actually progress in a positive direction if we fix one problem at a time, and then consider the next. The dialectical process doesn’t stop after a change in quantity begets its phase transition. We just move along to the next one. But simply because there will inevitably be a next one doesn’t mean we shouldn’t clean up the mess caused by the current one.