Wednesday, May 6, 2009

Seven Metaphors for Systemic Risk

I don’t think anyone understands systemic risk adequately, so efforts to prevent it will probably depend on metaphors to things that we understand better. But metaphors can mislead as well as inform. One way to avoid being misled is to have a variety of different metaphors for the same thing, and sort out what’s right and what isn’t from their conflicting suggestions. So here are seven ways of thinking about what systemic risk in the financial system is like:
  1. A machine breaking down

In a machine parts can break. With some parts, when they break the machine functions almost as it did before; other parts are critical to the functioning of the whole machine. Some machines, like the systems that provide life support for astronauts, have multiple redundancy in practically every component. Other machines are designed for reliability by having relatively few components, by having each component be highly reliable, or by monitoring and preventive maintenance of every critical component. In the financial system, a part that breaks and causes the whole system to malfunction can be a single too-big-to-fail company, but it can also be a cluster of interconnected firms, or a whole sector.

  1. Contagion

If each person who catches a disease infects, on average, at least one other person, then the disease will become an epidemic that grows exponentially until something changes so that the transmission rate falls below one again. Likewise, if each firm that goes bankrupt causes, on average, at least one other firm to go bankrupt, then there’s an epidemic of bankruptcy. Or if each dollar of loss in the value of one firm’s bonds causes a loss of a dollar in the total value of all the bonds of other firms that hold the first firm’s bonds, then there’s an epidemic loss of confidence in the ability of leveraged companies to meet their obligations.

  1. The system of alliances before World War I

The system was perfect. Nothing could possibly go wrong – unless everything went wrong, which of course it did.

  1. Resonance

The most familiar example is the Tacoma Narrows bridge collapse in 1940. If some aspect of the financial system has an equilibrium and a restoring mechanism that can overshoot, it may be subject to positive feedback that sends it farther from equilibrium until it collapses. I’m not aware of any dynamic in the financial system that works this way, but it is a possible way of looking at aspects of the crisis that we don’t understand.

  1. Phase change

Perhaps the metaphor of the credit flow “freezing” has some insight to offer. A complex system has many parameters, but typically some are not very significant. For example, in a gas it doesn’t make much difference how big the molecules are or how they can fit together, because there’s lots of room and the kinetic energy of the molecules is high enough that they don’t stick together. When values of some parameters change – temperature and pressure in the example – the parameters that were unimportant suddenly determine a new type of behavior.

  1. A cliff in the fog

Maybe there isn’t always anything much to know about how we get to the point of systemic troubles: maybe it’s just that no one is steering, or the people steering can’t see where we’re going.

  1. A twitchy racehorse

The people who brought us the financial crisis were supposed to be geniuses who were making everything work better. Well, maybe it’s true. Maybe achieving higher performance always involves pushing things to their limits, and always has drawbacks. Another example of greater responsiveness coming at a cost is in biochemistry. When researchers first discovered that we have different enzymes for the same reaction in opposite directions, they expected that we would never have both active at once. Such a “futile cycle” consumes energy while accomplishing nothing. But we do. It turns out that a metabolic pathway with a “futile cycle” can switch much more quickly from one direction to the other than one without. Demanding perfect switching ability, though, would mean that the cycle would have to consume an unlimited amount of energy. So we only have enough “futile cycle” activity to switch reasonably well. Our metabolism makes a compromise between plodding like a plow-horse and being ready to spring out of the gate like a racehorse. Our financial system may have to do likewise.

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