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The Best Science Writing Online 2012
Showcasing more than fifty of the most provocative, original, and significant online essays from 2011, The Best Science Writing Online 2012 will change the way...
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Editor's Note: This is the extended version of the "Sustainable Developments" column from the January 2009 issue of Scientific American.
The global economic crisis is akin to a power blackout. In both cases, a disturbance in one part of a complex “tightly coupled” system results in a cascade of failures through an entire network. In the case of a power blackout, a single downed power line or transient overload causes power to be shunted to another part of the grid, which in turn leads to new overloads, more shunting and ultimately to a cascade of failures that pushes a region into darkness. Similarly, in the current economic crisis, a U.S. banking emergency caused by worsening U.S. market forces has sent shock waves through the world’s financial system, causing a global banking crisis that now threatens to lead to a global economic downturn.
Cascading failures are an emergent phenomenon of a network, rather than the independent and coincidental failures of its individual components. Although it is true that many banks in the U.S. and Europe simultaneously overinvested in mortgage-backed securities (MBSs) to their peril, positive feedbacks in the global economic system amplified those errors. Bank regulators and macroeconomic policymakers have focused too much attention on the individual nodes of the network (that is, on each bank, and each national economy) without proper regard for the system-wide amplification.
Four kinds of economic feedbacks are key. The first is the “debt-deflation spiral.” When default rates on mortgages started to rise last year, the banks suffered capital losses on their holdings of MBSs. To repay their creditors (such as the money-market funds that had lent them short-term money), the banks sold their MBSs en masse, driving the market prices of those securities even lower and amplifying the banking sector’s losses.
Second, when banks suffer capital losses on bad assets such as MBSs, they cut back on lending by a multiple of their holdings of those MBSs. That cutback further depresses housing and other prices, reducing the value of the banks’ assets and amplifying the downturn.
Third, as one or more banks fail, panic ensues. Banks borrow short term to invest in longer-term assets, which the banks can liquidate quickly only at large losses. When a bank’s short-term creditors, such as the money-market funds, suddenly believe that other short-term creditors are withdrawing their loans, each creditor rationally tries to withdraw its own loan ahead of the others. The result is a self-fulfilling stampede to the exits, as was triggered worldwide in September 2008 by the failure of Lehman Brothers. Such “rational panics” can finish off otherwise solvent banks.
Fourth, the collapse in bank lending is quickly turning into a “main street” calamity. As banks cut back on their loans, consumer spending and business investment plummet, unemployment soars, and banks suffer further capital losses because more and more of their loans go sour. The real economy goes into a tailspin. Only aggressively expansionary fiscal and monetary policies in China, Japan, Germany and other countries with surpluses can avert that outcome in the current situation. The U.S. recession can no longer be avoided, but it can still be moderated in the U.S., and largely averted in East Asia, through expansionary macroeconomic policies.
The possibility of such amplifying feedbacks has been understood since the Great Depression, and some partial protections have been put in place. The main ones include capital adequacy standards that cushion individual banks against capital losses, emergency (lender-of-last-resort) loans from the central bank, deposit insurance and counter-cyclical macroeconomic policies. In practice these policies have been applied haphazardly, without regard for cross-border spillovers, and have generally been too little, too late. Nor was there any attention to building “firewalls” between countries, so that shocks in one part of the system would not quickly percolate to other economies. The global economy was being run at full throttle, without due attention to resiliency and vulnerability to shocks.
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6 Comments
Add CommentA fifth element is being to often underestimate: simple frauds and Ponzi schemes. If the priority is to make money from money, at the end
Reply | Report Abuse | Link to this<a href="http://mgiannini.blogspot.com/2008/12/recession-uncovers-what-auditors-cant.html">Recession uncovers what auditors can't</a>
"Fourth, the collapse in bank lending is quickly turning into a main street calamity." I refuse, why is everybody refusing to accept that people who earn less will not have money o pay, with wages been undercut over the last three decades it was going to happen sooner or later. The problem did not start in wall street it began with industry cutting costs when cutting costs was never the issue, making better products was the issue. Detroit has cut costs thousands of times in the last thirty years but they still make garbage cars, the knowledge going into their cars is not as great as that in Japan or Germany. Sachs unfortunately is acting like a herd economist, everybody says that I might as well say the same thing lest they cut my funding.
Reply | Report Abuse | Link to thisNot true, the problem did not begin in wall street it began with industry cutting costs instead of making better products than the competition. People are saying its wall street simply because they want to introduce regulation. Pity love is really what is lacking, if the industries really loved other human beings they would have made better products rather than reducing wages that at the end meant people could not pay their mortgages.
Can somebody please stand up to these evil people who are refusing facts in front of them, make better products and stop cutting wages so that people can afford to pay the mortgages what has wall street to do with that!!!!
The truth is by blaming wall street people are trying to pull of something sinister, we will only know why later
I mean their common peoples car are garbage, the good cars like Hummer the people can never afford
Reply | Report Abuse | Link to thisJeffrey D. Sachs spins a good yarn here. Yet, his story proves false.
Reply | Report Abuse | Link to thisThe economic collapse comes as an effect from the cause -- a massive credit bubble created by the Federal Reserve.
The Federal Reserve alone holds the monopoly charter on the manufacture and distribution of money and credit.
Member banks rented too much cash relative to the earnings power of Americans to pay debt service on such rented cash.
When buying power of the U.S. dollar fell beyond a tipping point, Americans could not pay for energy and food along with mortgages, home equity loans and credit card balances -- in short, their rented cash.
Once this became clear to foreign lenders, bankers experienced a giant margin call as their foreign lenders came to see that Americans could not service their debt.
Policy makers would do well to read Murray N. Rothbard's "America's Great Depression", the definitive and correct work on the subject and ignore Milton Friedman and Anna Schwartz's false work, "A Monetary History of the United States."
Commitment to excellence by improving constantly the product quality and couple the same with cost effectiveness so that the consumer gets products progressively improving in quality, at reducing prices, is the key to keep the consumption up beat and add wealth too because the purchasing power of the currency is sustained. This leads to sustained jobs and surplus incomes to enable spending. This in my mind is very critical core issue of building up an economy.
Reply | Report Abuse | Link to thisThen the same qualities should reflect in financial services and banking too. That means Ponzi schemes and similar conscious fraudulent games should be treated as crimes and the white collar criminals should not get the extended goodwill treatment. The regulators and the systems have notoriously played shut eye even though the signs were glaring.
The quality of lending keeping in view the debtor's capacity to pay is a fundamental issue, which again was compromised and that too knowingly. It is as much failure of the state regulators as well as that of the herds on the go to make quick commissions; make hay while the sun shines.
Then highly placed economists making it out as some complex phenomenon for which no one should be accountable is admirable in the face of so much real pain around, but this attitude will only lay the foundation for the next bout of more serious and severe bubble burst.
Yes the network approach to describe the collateral damage is fine but it is not the network which caused triggered the melt down. Fundamentals were forgotten in the glitz created by some monsters of creative get-rich-quick players who produced funny money and illusory wealth.
This editorial is a refreshing and insightful addition to the otherwise regretfully shallow economic conversation that permeates the public media. Permit me to add and additional dimension to this dialogue, a comment on perils in seeking the holy grail of economic stability.
Reply | Report Abuse | Link to thisThe mathematical analysis of the stability of dynamical systems teaches us that any system with a stable operational domain, surrounded by a region of instability, can be modified by local perturbations to create a larger domain of stability, euphemistically viewed as a more stable system. This may be simply an engineering version of Whac-A-Mole. The increased stability usually comes at a cost: The "stabilized" system is subject to more catastrophic failures if the boundary of instability is ever breached. The mathematics suggests that naive engineering to increase stability often enhances the risk of more catastrophic failures.
Let us illustrate this concept with a simple example. Suppose we were condemned to wander with others in a fog near a precipice. After observing a couple of disappearances of our peers, we decide on a strategy of holding hands with several of our colleagues. As the days pass, we are reassured when an occasional solo miss-step fails to lead to tragedy, as the errant ones are quickly pulled to safety. One day, several missteps occur simultaneously, and the entire party is pulled over the cliff. The cost of the enhanced local stability is the risk of a far-reaching calamity.
We have seen this process in practice. When we tire of local electrical blackouts, we arrange for hand-holding over an extended power grid, and have observed a reduction in local blackouts, at the expense of occasional regional blackouts. Some savants suggest the cure of an international grid. We protect against local bank liquidity crises by creating central banks with the power to dispense liquidity at a national level. When that system teeters, the suggested fix is to have the central banks hold hands.
These naive approaches are attempts to apply quick fixes without understanding the underlying problem. They are akin to applying Band-Aids without investigating the nature of the wound.
Economic systems are not amenable to the same degree of mathematical analysis as the control of mechanical systems, where the applicable laws of physics are well understood. A fundamental feedback in a social system is that regardless of how well it is designed, greed may attract some participants into attempting to game the system recklessly, ignoring its perils in their quest for personal riches. Introducing mechanisms to forgive their follies may not enhance stability, but might have the opposite effect of encouraging reckless behavior. Reading numerous biographies of the financially successful, I am impressed with how often they have endured numerous bankruptcies along the path to their ultimate success. Were they brilliant or simply gambling with other people's money? I have found no accompanying literature to enlighten me about those who endured numerous bankruptcies and never achieved success. What would be the damage to the economy if we all behaved so recklessly? Is "concerted reckless action" a synonym for "financial bubble"?
Perhaps we are naive to believe that we can have a stable capitalist economy without facilitating the creative destruction of inefficient entities. Perhaps allowing easy rescues through Chapters 11 & 12 bankruptcy reorganizations postpones tragedies for individuals at the expense of the health of the entire marketplace. Perhaps even Chapter 7 bankruptcy (liquidation) should not excuse one from future repayments if there are ensuing extraordinary financial successes.
To our peril, we seem to be relying on banking technicians rather than market philosophers. Beware of "experts" who mindlessly worship at the alter of "bigger is better". Is an unintended consequence of bale-outs the encouragement of gambling with taxpayer money? Does one dare to investigate whether our current political-economic system is fundamentally flawed? For example: Do our current implementations of free market capitalism and representative democracy have inherently unstable interactions? Applying haphazard fixes without regard to understanding of the underlying problems is simply playing Whac-A-Mole with our financial system.