Arnold Kling  

Finance as a Network

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Andrew G. Haldane recommends using an ecology/network metaphor to understand the financial system.


An external event strikes. Fear grips the system which, in consequence, seizes. The resulting collateral damage is wide and deep. Yet the triggering event is, with hindsight, found to have been rather modest. The flap of a butterfly's wing in New York or Guangdong generates a hurricane for the world economy. The dynamics appear chaotic, mathematically and metaphorically.

Implicit in this story is the notion that there was nothing so horribly unsound about the balance sheets of the key financial firms. There was just a contagious financial panic.

This issue is one of ongoing controversy. I have always leaned in the direction of viewing the balance sheet problems as genuine, rather than blaming pure panic. But there are plenty of folks who take the opposite view. Like Haldane, they tend to be in the policy-making community rather than in what I call the peanut gallery.


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COMMENTS (7 to date)
ThomasL writes:

I wonder how, if attributed to panic, one attempts to justify spending (at the absolute barest of minimums) $2,000,000,000,000 dollars on some grand romantic gesture.

Panic is pretty tricksy, but I don't think you can just bribe it.

Les writes:

Implicit in this story is the author's attribution of a phenomenon to a metaphor, which suggests that:

a) He does not understand balance sheets, and/or

b) He does not understand the scientific method, which seeks factual evidence and cause-effect relationships, rather than making unfounded assumptions about untestable "metaphors."

Lee Kelly writes:

Attempting to stimulate the economy with monetary and fiscal policy is just hubris.

When money enters the economy from the Federal Reserve, it enters at a particular location. Whichever industries receive the money first will benefit. Inflating to clear the market will not increase the use of resources uniformly; some sectors will disproportionately draw material, labour, etc. toward them. But the flow of additional resources into the stimulated industry is unsustainable. Once the money injections cease, prices will adjust, and the resources will again be re-allocated. Businesses which should never have received capital in the first place, should not be subsidised to continue operating. A stimulus will do nothing but delay the capital reformation necessary to put the economy back upon a sustainable growth path.

Resources have been squandered on goods and services which people cannot afford i.e. do not want to buy at the price necessary for borrowers to pay off their debts. Before the bubble burst, demand was sufficient to make such goods and services profitable, but only because the boom created an illusion of wealth. Once reality reasserted itself, people realised that their spending was too loose, i.e. they had bought goods and services which they never would have if they understood the true value of their assets.

Aggregate demand was artificially inflated from the last round of monetary and fiscal stimulus, and was unsustainable, incompatible with economic reality. The solution is to let prices fall until they correctly signal the boom's malinvestments. Only then can resources be redeployed, by the market, to creating goods and services that people actually want to buy.

Even the "secondary deflation" is important, because it tells us something real about the world, namely, the corrupted state of economic knowledge. It might be called a drop in confidence or restless animal spirits, but it could also be called a loss of knowledge.

When investors' expectations of the economy are shattered, it's like telling someone that everything they believe is false--suddenly the world seems like a much more risky place. Although some investors might panic needlessly, others inevitably will be caught up in the crash. Shouting out, "all is well, all is well, so carry on as before!" to boost confidence is foolish, since all is not well--economic knowledge has just become a lot scarcer. Investor confidence will need to return, but what exactly should investors be confident in? Without answering that question right, we could just be setting up the next round of malinvestment. This question that can only be competently answered by the discovery process of the market--a trial by prices.

It seems to be that the appeal of "Keynesian" economics is that we can somehow, by printing money, reshuffling banks assets, or selling government bonds, avoid suffering for past mistakes. But once the mistakes were made, someone, somewhere, was going to suffer for it. All the government can do with all its meddling is redistribute who pays, and perhaps increase the eventual cost along the way. "Keynesian" economics is ike Alchemy, both in that it offers the promise of something extraordinary and does not work. You cannot magic-away the real cost of squandering so many resources during the boom, nor the loss of knowledge which follows.

Josh writes:

It's interesting to consider whether the economy can be modeled by the emerging field of complex networks. If economic actors formed a scale-free network, and the number of links between them correlated with income, you'd expect income distribution to follow a power law.

The network would also be especially susceptible to contagion.

Mark Seecof writes:

Well, at least one corner of the market, which was the foundation of an awful lot of leverage, was truly unsound: CMO's based on loans in housing bubble markets like California. The simple fact is that many borrowers never could have paid back their borrowings from earnings; they were all counting on continued rapid appreciation. Eventually the housing market ran out of greater fools, the music stopped, and many participants' asses landed on the floor instead of in chairs.

fundamentalist writes:

I think in a more dispassionate future people will blame Bernanke and Paulson for screaming fire in a crowded theater.

George writes:

OK, so the flap of a butterfly's wings in Brazil causes a hurricane in Florida. That means building your home on the beach in Florida at grade with no bracing or tie-downs for the roof doesn't cause hurricanes....

...so it's OK to go ahead and do so? Uh, no.

If we can count on disasters happening irregularly and unpredictably (more or less like hurricanes), that's more reason to take a conservative, defensive approach. In home construction, that means building things back from the water, on pilings, and securing the roof.

In banking, that means not having a balance sheet full of crap (whether or not you sincerely believe it's low-risk), and having lots of reserves.

Another metaphor: washing your hands and dishes and floors all the time almost never prevents you from getting a disease. At least 90% of all that effort is wasted. But since you can't tell when (say) your kids are going to bring home something from school, it's a fine investment, saving many times the cost in time, and possibly your life.

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