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.

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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.