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.