It is rare to find a highly original and timely paper on something as vital as the global financial crisis.
A reader has alerted Henry to a recent paper that draws conclusions about how to contain the global financial crisis based on the history of epidemics such as yellow fever and cholera in the 19th century to polio and influenza in the 20th. It is a mystery that this paper has not (so far as Henry is aware) so far been publicised in this country.
The author is Andrew G Haldane, Executive Director, Financial Stability, Bank of England. His contribution came in a speech delivered at the Financial Student Association, Amsterdam in April 2009.
“This paper considers the financial system as a complex adaptive system. It applies some of the lessons from other network disciplines - such as ecology, epidemiology, biology and engineering - to the financial sphere. Peering through the network lens, it provides a rather different account of the structural vulnerabilities that built-up in the financial system over the past decade and suggests ways of improving its robustness in the period ahead.
“Two characteristics of the financial network over the past decade - complexity and homogeneity - resulted in a financial network:
- which was at the same time both robust and fragile - a property exhibited by other complex adaptive networks, such as tropical rainforests;
- whose feedback effects under stress (hoarding of liabilities and fire-sales of assets) added to these fragilities - as has been found to be the case in the spread of certain diseases;
- whose dimensionality and hence complexity amplified materially Knightian uncertainties in the pricing of assets - causing seizures in certain financial markets;
- where financial innovation, in the form of structured products, increased further network dimensionality, complexity and uncertainty; and
- whose diversity was gradually eroded by institutions’ business and risk management strategies, making the whole system less resistant to disturbance - mirroring the fortunes of marine eco-systems whose diversity has been steadily eroded and whose susceptibility to collapse has thereby increased.
“This evolution in the topology of the network meant that sharp discontinuities in the financial system were an accident waiting to happen. The present crisis is the materialisation of that accident”.
Haldane provides some “tentative policy prescriptions”:
“The experience of other network disciplines suggests a rather different approach to managing the financial network than has been the case in the past, if future systemic dislocations are to be averted. Three areas in particular are discussed:
- Data and Communications: to allow a better understanding of network dynamics following a shock and thereby inform public communications. For example, learning from epidemiological experience in dealing with SARs, or from macroeconomic experience after the Great Depression, putting in place a system to map the global financial network and communicate to the public about its dynamics;
- Regulation: to ensure appropriate control of the damaging network consequences of the failure of large, interconnected institutions. For example learning from experience in epidemiology by seeking actively to vaccinate the 'super-spreaders' to avert financial contagion; and
- Restructuring: to ensure the financial network is structured so as to reduce the chances of future systemic collapse. For example, learning from experience with engineering networks through more widespread implementation of central counterparties and intra-system netting arrangements, which reduce the financial network’s dimensionality and complexity.”
Clearly the world, and its financial system, has become more complex.
Haldane compares finance theory to ecology:
“Complexity strengthened self regulatory forces in systems, so improving robustness. This was the prevailing ecological wisdom up until the early 1970s.
“That conventional wisdom has since been turned on its head. From the 1970s onwards, orthodoxy was altered by a combination of enriched mathematical models and practical experience. Counter-examples emerged, with some simple eco-systems - savannas and grasslands - found to exhibit high robustness and some complex ecosystems proving vulnerable to attack. Perhaps tellingly, large-scale clearance of tropical rainforests highlighted their inherent fragility. Not for nothing did rainforests become known as a 'non-renewable' resource from the early 1970s.
“Finance appears to be following in ecologists” footsteps, albeit with a generational lag. Until recently, mathematical models of finance pointed to the stabilising effects of financial network completeness.
“Connectivity meant risk dispersion. Real-world experience appeared to confirm that logic. Between 1997 and 2007, buffeted by oil prices shocks, wars and dotcom mania, the financial system stood tall; it appeared self-regulating and self-repairing. Echoes of 1950s ecology were loud and long.
“The past 18 months have revealed a system which has shown itself to be neither self regulating nor self-repairing. Like the rainforests, when faced with a big shock, the financial system has at times risked becoming non-renewable. Many of the reasons for this have a parallel in other disciplines. In particular, in making sense of recent financial network dynamics, four mechanisms appear to have been important: connectivity; feedback; uncertainty; and innovation”.
The remainder of this fascinating paper draws out the analysis and relates the recent breakdown of the global financial system to previous epidemics.
The full paper is reproduced here (PDF 492KB) and the link to the Bank of England site is here (PDF 498KB).
It is the most insightful economic analysis I have seen for 30 years, and deserves to be widely read, and not just by central bankers and financial system regulators.
Haldane's conclusion is simple and to the point:
“Through history, there are many examples of human flight on an enormous scale to avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th century to polio and influenza in the 20th. In these cases, human flight fed contagion and contagion fed human catastrophe. The 21st century offered a different model. During the SARS epidemic, human flight was prohibited and contagion contained.
“In the present financial crisis the flight is of capital, not humans. Yet the scale and contagious consequences may be no less damaging. This financial epidemic may endure in the memories long after SARS has been forgotten. But in halting the spread of future financial epidemics, it is important that the lessons from SARS and from other non-financial networks are not forgotten”.
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