Story of a Bubble

Once upon a time, there were two people. Let's call them "you" and "me". Each of us had a penny. One day, a stranger came along and sold me a lump of clay. It was fun to play with, and I thought I might be able to make a clay pot out of it eventually. So I bought it with my penny. The next day, you saw I was having fun playing with my clay, so you offered to buy half of it from me, with your penny. The day after that, I realized that I had made a whole penny of profit off of buying a penny's worth of clay, so I thought buying back some of the clay would be worth a try. You agreed to sell me half of what you had. On day four, you notice that there's a hitorical trend, where the clay market pays a good return. You can see that this justifies reinvesting at a fair price, eight cents per lump. Each day, one of us made a profit, while the other prudently invested the previous day's profit.

In a few weeks, we were both clay-market millionaires -- even though all we had was still that same penny and that same lump of clay. It didn't require any artificially low interest rates, any increase in the money supply, any repackaging of clay-backed securities, any buying on margin, any phony bond ratings. It didn't take any particularly remarkable characteristics of clay. All it took was a market with no reality check.

Of course, it did require that disconnect from reality: it's completely unreasonable to think that a lump of clay is worth a million dollars, particularly when you bought it for a penny the month before. But the disconnect isn't normally so obvious. Lots of things really do grow exponentially, at least for a while, so it's not at all unreasonable to think that the price of houses or gold might do so. And a small difference in exponential growth rates will soon lead to a big difference in the actual numbers. All it takes is a market with no reality check.

Markets are magic. That's not just a quasi-religious belief of the financial elite in this country. It's a theorem. Not a theory, but a theorem: a precise mathematical statement with a proof. The problem is, the theorem doesn't say what the ideological doctrine says it does. With a theorem, you don't get to conclude the conclusion unless the hypotheses are true. Markets are very good at aggregating certain kinds of information. But the information has to come from outside the market: in effect, from reality. Producers produce, consumers consume, and the market connects the two so that the stuff is neither accumulating in inventory nor getting depleted from inventory. It can even still work if middlemen get paid to store inventory at harvest time and release it gradually over the course of the year, or if speculators get paid to bear more than their share of financial risk -- as long as it comes out even over the whole cycle, with demand ultimately from consumers and supply ultimately from producers. But if the demand for something comes from investors buying it to sell later, while the supply comes from previous investors disinvesting, to the point where any actual producers and consumers are irrelevant, then the whole thing has come untethered from reality. And it's free to go floating skyward, expanding until reality finally does intrude and it bursts.

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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.