Positive Linking and Financial Crises

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This is the sec­ond of two con­tributed pieces by Paul Ormerod, the author of Pos­i­tive Link­ing and, as I noted in my last post, in my opin­ion the most effec­tive devel­oper of multi-agent mod­els of the econ­omy.

 Did Econ­o­mists Go Mad? Net­works and the Eco­nomic Crisis

The con­duct of eco­nomic pol­icy mak­ing over the ten to fif­teen years prior to the finan­cial cri­sis of 2008–9 exem­pli­fies the fun­da­men­tal prob­lems of the con­ven­tional mind­set of eco­nom­ics. At the time, it seemed as though clever pol­icy mak­ers devis­ing clever rules and reg­u­la­tions to set the right incen­tives, to which eco­nom­i­cally ratio­nal agents would respond appro­pri­ately, had indeed solved key prob­lems of macro­eco­nomic man­age­ment. Eco­nomic growth in the West was strong and steady, and both unem­ploy­ment and infla­tion every­where remained low.

Net­works were con­spic­u­ous by their com­plete absence from the intel­lec­tual frame­work of pol­icy mak­ers. Yet net­work effects were absolutely cen­tral to the causes of the cri­sis.

There had been a num­ber of scares along the way. In 1997–8, the rapidly grow­ing area of East Asia expe­ri­enced a finan­cial cri­sis, with huge falls in out­put and employ­ment through­out the region in 1998. But very soon growth and ris­ing pros­per­ity were restored. Net­work effects fea­tured strongly in both the crash and the recov­ery. Doubts began to emerge about the econ­omy of Thai­land. In par­tic­u­lar, there were wor­ries – har­bin­ger of big­ger things to come ten years later – about whether the coun­try was expe­ri­enc­ing an unsus­tain­able real-estate bub­ble. The Thai cur­rency came under attack, and the gov­ern­ment cut its link, its fixed value, to the US dol­lar. This was the sig­nal for mas­sive spec­u­la­tion against the cur­rency and a sharp fall in its value.

But the cri­sis then spread like wild­fire across almost every sin­gle coun­try in the region. Even China, then nowhere near as con­nected to the rest of the world as it is now, suf­fered from a loss of for­eign con­fi­dence. The finan­cial col­lapse led to dra­matic falls in out­put in many of the coun­tries, with soar­ing unem­ploy­ment.

Then, almost as sud­denly, con­fi­dence returned, across both the net­works of finan­cial mar­kets and the net­works which cre­ate busi­ness con­fi­dence, or lack of it, in the domes­tic economies of the region. Why? Well, as the old say­ing goes, suc­cess has many fathers and fail­ure is an orphan. The IMF was widely blamed for its role dur­ing the cri­sis, but claimed credit for restor­ing sta­bil­ity and paving the way for recov­ery. Even now, despite over a decade of the most inten­sive study by econ­o­mists, we do not have an agreed answer to the ques­tions why the economies col­lapsed so spec­tac­u­larly but then, very quickly, bounced back as though noth­ing had hap­pened. Net­works have played lit­tle part in any of this analy­sis, but were undoubt­edly the key.

So, a mas­sive cri­sis in East Asia, the sub­se­quent default on its debt by the Russ­ian gov­ern­ment, the col­lapse of Long Term Cap­i­tal Man­age­ment in Amer­ica, the col­lapse of the dot.com bub­ble. Any sin­gle one of these might have trig­gered a world­wide cri­sis. But what might at any moment have turned into a blood­bath seemed to have been averted by the new-found skill and knowl­edge of pol­icy mak­ers, equipped not just with the long­stand­ing tools of incen­tives but with the insights pro­vided by the con­cept of ‘mar­ket fail­ure’.

The intel­lec­tual under­pin­nings for the appar­ent mir­a­cle were pro­vided by eco­nomic the­ory. Olivier Blan­chard is the chief econ­o­mist of the IMF. Here is what he had to say in August 2008 in an MIT work­ing paper enti­tled ‘The State of Macro’: ‘For a long while after the explo­sion of macro­eco­nom­ics in the 1970s, the field looked like a bat­tle­field. Over time, how­ever, largely because facts do not go away, a largely shared vision both of fluc­tu­a­tions and of method­ol­ogy has emerged . . . The state of macro is good.’ The state of macro is good! In August 2008!

A few weeks later Lehmans went bank­rupt. Cap­i­tal­ism itself was on the brink of another Great Depres­sion on the scale of the 1930s when unem­ploy­ment in the USA reached nearly 25 per cent. The period which had been dubbed the Great Mod­er­a­tion, when pol­icy mak­ers seemed to have been granted the touch of King Midas, in real­ity proved to be the Great Delu­sion.

Grad­u­ally, doubts began to seep across the net­work of banks, doubts about whether it was pos­si­ble to know the true poten­tial extent of losses of another bank to which money had been lent. Once banks became uncer­tain about whether they under­stood the true finan­cial posi­tions of other banks, they became reluc­tant to lend to each other.

Indeed, in August 2007 they sim­ply stopped doing so, more or less com­pletely. A real, no-holds-barred credit crunch.

The prob­lem was not spe­cific to any one bank, not spe­cific to any incen­tives, any spe­cific pric­ing of risk which had been under­taken. It was a net­work effect. A net­work effect which gripped most of the world’s bank­ing sys­tem. One moment every­thing seemed fine and banks were happy to buy and sell these very com­pli­cated secu­ri­tised bun­dles of loans. The next, almost in a twin­kling of an eye, they were not. Indeed, they were extremely reluc­tant to carry out almost any sort of inter-bank trade, and specif­i­cally they stopped being will­ing to lend.

The price of each indi­vid­ual, iso­lated trans­ac­tion had appar­ently been set opti­mally, the risk asso­ci­ated with it had been cor­rectly assessed and taken into account. But banks had to believe that this was so. The belief had to be sus­tained across the net­works on which the opin­ions and sen­ti­ments of bankers are formed. In Keynes’s phrase, the bankers were ‘a soci­ety of indi­vid­u­als each of whom is endeav­our­ing to copy the oth­ers’. If they copied the opin­ion, the belief, that every­thing was fine, it would con­tinue to be so.

But once they stopped believ­ing, we had a credit crunch.


Banks, reg­u­la­tors, gov­ern­ments believed that the prob­lem of pric­ing risk had been solved. Despite occa­sional doubts, occa­sional shocks, this belief per­sisted. Then, sud­denly and dra­mat­i­cally, doubts about this spread like the Black Death across the net­works of sen­ti­ment that run through finan­cial insti­tu­tions. And once this had hap­pened, unlike Peter Pan exhort­ing the chil­dren to believe in fairies to save Tin­ker­bell from death, the author­i­ties – reg­u­la­tors, gov­ern­ments, inter­na­tional insti­tu­tions – found it impos­si­ble to exhort the banks to believe. Net­works swamped all their efforts to restore con­fi­dence. Pes­simism spread like wild­fire.

Much pub­lic­ity and con­tro­versy sur­rounded the set­ting up of the result­ing Trou­bled Asset Relief Pro­gram (TARP), a $700-billion bail-out fund which required polit­i­cal approval and so was played out in full light of the demo­c­ra­tic process in Amer­ica. But in many ways this was of second-order impor­tance to the purely admin­is­tra­tive actions of the Amer­i­can author­i­ties, who:

• nation­alised the main mort­gage com­pa­nies, Fan­nie Mae and Fred­die Mac;

• effec­tively nation­alised the gigan­tic insur­ance com­pany AIG;

• elim­i­nated invest­ment banks;

• forced merg­ers of giant retail banks; and

• guar­an­teed money-market funds.

The key point about all these actions is that the Amer­i­can author­i­ties paid no atten­tion to aca­d­e­mic macro­eco­nomic the­ory of the past thirty years. Real Busi­ness Cycle the­ory, Dynamic Sto­chas­tic Gen­eral Equi­lib­rium mod­els, ratio­nal expec­ta­tions – all the myr­iad eru­dite papers on these top­ics might just as well have never been writ­ten.

Instead, the author­i­ties acted. They acted imper­fectly, in con­di­tions of huge uncer­tainty, draw­ing on the lessons of the 1930s and hop­ing that the mis­takes of that period could be avoided. It was not a grand plan, nor did one ever exist. This was a process of peo­ple respond­ing to events on the basis of imper­fect knowl­edge and exper­i­ment­ing to dis­cover what did and did not seem to work, des­per­ately try­ing to restore con­fi­dence across finan­cial net­works. And net­works were impor­tant to the out­comes, to the deci­sions which were made, at a very detailed level.

Con­fi­dence across net­works was key. Con­fi­dence across net­works of finan­cial insti­tu­tions that the monies owed to them by oth­ers would be paid. Con­fi­dence across net­works of com­mer­cial com­pa­nies that out­put was not about to col­lapse like it did in the 1930s, so that they would then not act in ways which made this a self-fulfilling prophecy. And con­fi­dence across net­works of indi­vid­u­als that their worlds were not about to fall apart.

What they came up with worked. Amer­i­can GDP in 2009 fell by some 4 per cent com­pared to 2008, and by the autumn of 2011 the econ­omy had not only sta­bilised but had grown for nine suc­ces­sive quar­ters. Indeed, by the third quar­ter of 2011, growth was suf­fi­ciently strong that the level of US GDP rose above its pre-crisis peak. (In con­trast, between 1929 and 1930, the first year of the Great Depres­sion, GDP fell by nearly 9 per cent, and the cumu­la­tive drop between 1929 and 1933 was 27 per cent.) Unem­ploy­ment was still high, but employ­ment had risen. The sta­bil­i­sa­tion pro­gramme worked, and a cat­a­strophic col­lapse in out­put dur­ing 2009 was averted. It pre­vented pes­simism and panic from per­co­lat­ing across net­works.

It is a spec­tac­u­lar suc­cess of pos­i­tive link­ing. The spe­cific details of the mea­sures which were taken were in gen­eral of second-order impor­tance com­pared to the suc­cess in pre­vent­ing the sen­ti­ment from spread­ing that Amer­ica was about to suf­fer a re-run of the Great Depres­sion of the 1930s.

The cri­sis in Europe dur­ing 2011/12 has mainly arisen through a fail­ure of Euro­zone gov­ern­ments to gen­er­ate any­where near the same degree of pos­i­tive link­ing of sen­ti­ment across finan­cial net­works. We can use­fully think of much of the eco­nomic pol­icy in Europe as being not about spe­cific mea­sures in par­tic­u­lar, the sort of thing which main­stream econ­o­mists get excited about and whose impact they con­tinue to believe they can mea­sure, but about the des­per­ate attempts by key pol­icy mak­ers to spread pos­i­tive sen­ti­ment across the mar­kets.

One thing is clear. Con­fi­dence is only weakly related to objec­tive real­ity, to the actual facts. The prin­ci­pal con­cern is about pub­lic sec­tor debt. In the case of Greece, the con­cern is entirely mer­ited. Com­pared to the size of out­put in Greece (GDP), pub­lic sec­tor debt is approach­ing 150 per cent, and there are few encour­ag­ing signs of a will­ing­ness to get to grips with the prob­lem. With inter­est rates at around 7 per cent, this means that some 10 per cent ( 7 per cent of 150 per cent) of the total spend­ing of the Greek gov­ern­ment is going not on pro­vid­ing any form of ser­vices, but on pay­ing the inter­est on its debt.

The com­pa­ra­ble fig­ure for Spain is only 60 per cent. Yet Spain, too, has expe­ri­ence repeated crises of con­fi­dence in the mar­kets, and its inter­est rates have hov­ered around 7 per cent. In con­trast, the inter­est rates on gov­ern­ment debt in both the UK and Ger­many are not much more than 2 per cent, even though pub­lic sec­tor debt is 80 per cent of GDP in the UK and nearly 85 per cent in Ger­many. Obvi­ously pub­lic debt is not the sin­gle cause of the lack of con­fi­dence, but the Japan­ese cur­rency is per­ceived of as being strong despite a pub­lic debt ration of nearly 200 per cent.

Poli­cies which gen­er­ate con­fi­dence are, once again, not so much the spe­cific details, the eco­nom­i­cally ‘ratio­nal’ cal­cu­la­tion of their poten­tial con­se­quences, but the cre­ation of a pos­i­tive mind set, a pos­i­tive atti­tude on finan­cial mar­kets. Pos­i­tive link­ing.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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7 Responses to Positive Linking and Financial Crises

  1. Steve Hummel says:

    Inter­est­ing post indeed.

    If they copied the opin­ion, the belief, that every­thing was fine, it would con­tinue to be so. But once they stopped believ­ing, we had a credit crunch.”

    Inter­nal real­ity, i.e ideas, val­ues and expe­ri­ences is always more pow­er­ful than mere struc­ture espe­cially when that “struc­ture” is some repo’d and rehy­poth­e­cated wigged out non­sense. Only the utterly unwise and fran­ti­cally profit pur­su­ing could not under­stand that. Maybe we could change the dis­crip­tion of eco­nom­ics from “the dis­mal sci­ence” to…the blind and unwise one.

    Poli­cies which gen­er­ate con­fi­dence are, once again, not so much the spe­cific details, the eco­nom­i­cally ‘ratio­nal’ cal­cu­la­tion of their poten­tial con­se­quences, but the cre­ation of a pos­i­tive mind set, a pos­i­tive atti­tude on finan­cial mar­kets. Pos­i­tive linking.

    I like that. Although poli­cies which are based on and aligned with the ideas, val­ues and expe­ri­ences of Con­fi­dence, Hope, Love and Grace are ones we can also trust.

    For a primer on such a theory/system here is a Kin­dle and soon to be print ready book that imag­ines just such a linking/bind back.


  2. David Crist says:

    This is my first post here and I’m sorry to start by being off topic but I was astounded by this arti­cle by Ambrose Evans Pritchard in The Tele­graph today and the IMF Work­ing Paper it refers to: IMF’s epic plan to con­jure away debt and dethrone bankershttp://www.telegraph.co.uk/finance/comment/9623863/IMFs-epic-plan-to-conjure-away-debt-and-dethrone-bankers.html. Have you read this article/IMF Report Mr. Keen? Any thoughts?

  3. F. Beard says:

    Banks, reg­u­la­tors, gov­ern­ments believed that the prob­lem of pric­ing risk had been solved. Paul Ormerod

    Our money sys­tem, a gov­ern­ment backed/enforced usury for stolen pur­chas­ing power car­tel, is sys­tem­at­i­cally risky because it forces the entire pop­u­la­tion into debt (or be priced out of the mar­ket by those who do bor­row), because the usury requires accel­er­at­ing debt with­out suf­f­i­cent defict spend­ing (new money) by the mon­e­tary sov­er­eign and/or a suf­f­i­cent trade sur­plus and because, as Pro­fes­sor Keen points out, noth­ing can accel­er­ate forever.

  4. Steve Keen says:

    I’ll check it out. I expect it refers to Michael Kumhof’s paper on the Chicago Plan. Michael is a DSGE mod­eler who, in con­trast to the vast Neo­clas­si­cal throng, rec­og­nizes the impor­tance of banks, debt and money in eco­nom­ics and is mod­i­fy­ing DSGE mod­les to incor­po­rate them. He’s also very open to non-Neoclassical tech­niques. We’ve become good friends, and I’m look­ing for­ward to meet­ing up with him in Wash­ing­ton next month.

  5. Steve Hummel says:

    Eco­nomic reset is needed, but it’s not the com­plete solution.

    The prob­lem is not whether its Bankers who rule or the State. It’s both the monop­oly on credit and the will to power of the sys­tem over the indi­vid­ual which is most rel­e­vant. The Aus­tri­ans believe that can be accom­plished by let­ting the free mar­ket deter­mine things. Prob­lem is under the cur­rent account­ing con­ven­tions a truly FREE, free mar­ket does not and can­not exist. The same prob­lem will exist when the State “con­trols” money. The cur­rent monop­oly is actu­ally a tri­opoly of Pri­vate banks, Cen­tral Banks and their lap dog the Gov­ern­ment so you’re just trans­fer­ring the power to Gov­ern­ment which is simul­ta­ne­ously the strongest and weak­est aspect of the tri­opoly. Strongest because its word is law, weak­est because gov­ern­ment can change. But with the power of money being trans­ferred to gov­ern­ment you have prob­a­bly a greater poten­tial tyranny. Mam­mon and Leviathan are equal and cozy mates, and the con­ven­tions of cost account­ing is their secret ally in alter­nat­ing chaos and author­i­tar­ian con­trol. Only Grace, the free gift of money and the inten­tion of set­ting the indi­vid­ual free is up to com­bat­ing them. Grace makes the sys­tem free flow­ing, the inten­tion keeps the sys­tem humane instead of dominating.

  6. Ed Beaugard says:


    Yet net­work effects were absolutely cen­tral to the causes of the crisis.”

    I don’t under­stand what talk­ing about net­works adds to eco­nom­ics. It seems to me to be a tech­ni­cal term that merely means some­thing like Keynes’ “ani­mal spir­its”. Of course, “net­works of autonomous agents” can be mod­elled mathematically(I guess), but again, to what pur­pose? Like the idea, “emer­gent prop­er­ties”, the word “net­works” doesn’t explain any­thing, in my opin­ion.
    More wor­ry­ingly, the use of ideas like “emer­gent prop­er­ties”, and “net­works” gives an entirely false sense that some­how we can be more exact or pre­cise than is really pos­si­ble. This is so because Keynes was cor­rect in say­ing that eco­nom­ics is a moral and not a nat­ural sci­ence.
    Or, maybe Keynes was wrong, and eco­nom­ics is or can be a nat­ural sci­ence and we can all hap­pily with­out fur­ther thought, apply math­e­mat­i­cal and sta­tis­ti­cal meth­ods from the sci­ences to economics.

  7. Ed Beaugard says:

    Err…yes. And maybe Keynes was also wrong and eco­nomic data IS homoge­nous through time. There­fore, econo­met­rics is valid as well as a lot of the other math­e­mat­i­cal tech­niques devel­oped by the neo-classicals.

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