Time to Update the Priors: Not All Policies Matter for All Outcomes

In response to my previous post Mark Thoma and I had a bit of a roundabout on Twitter. His first point is that he wasn't addressing our article in his blog post. I mentioned in my post that that was obviously the case, even though he quoted Farrell's summary of it before launching his discussion on unrelated topics. But through the Twitter discussion several interesting topics were raised. Thoma asked me two main questions:

1. Is it your argument that peripheral crises can never lead to systemic crises?

2. Is your answer to #1 completely independent of crisis response policies?

My response to #1 is that the likelihood is exceedingly low. I base that on the fact that not a single peripheral crisis* from 1970-present (using the IMF's database) has turned into a systemic crisis. Obviously crisis management policies have varied quite a lot, but the global (i.e. systemic) outcome has not.

That leads me to believe that policy considerations are not very important from the perspective of preventing systemic contagion from peripheral crises. In peripheral crises, policy matters a lot locally -- i.e. for the peripheral country experiencing the crisis and maybe one or two others connected to it -- but not systemically. In systemic crises, policy in the core matters a lot globally; policy in the periphery matters less**.

Thoma disagreed. Obviously that's fine, but I'd like to explain why I think he's wrong. Since I've heard others make it in plenty of other contexts, I thought I'd make the point here. These Tweets of his seems to sum up his view, which I believe is a common view:

@whinecough @dandrezner So if ridiculous policy enacted, you wouldn't worry (see first proposal)? Glad policymakers didn't share that view.
— Mark Thoma (@MarkThoma) March 26, 2013

@whinecough @dandrezner You're right. I can't prove what would have happened under an alternative policy. But not willing to risk it.
— Mark Thoma (@MarkThoma) March 26, 2013

@whinecough @dandrezner Again, this is a very simple question.Either policy in Cyprus could have mattered, or not. We disagree on the answer
— Mark Thoma (@MarkThoma) March 26, 2013

We went around like that for awhile. So here's my position: if policy mattered for global outcomes things would likely be much more worse right now than they are. Why? Because the Cyprus deal is basically the worst possible policy from the perspective of preventing contagion. Cyprus has been hacked off from the global financial system. Capital controls are in force. Its entire banking system has been closed for two weeks, its second-largest bank will be closed permanently, and its largest bank will be forcibly restructured. Foreign depositors, bondholders, and shareholders are being gutted.

If you were trying to start a systemic crisis, this is the way you would do it: repudiate a huge chunk of claims, and close the capital account. And yet markets around the world are up today. Even in Russia.

Or take the examples of Iceland and Ireland. Iceland repudiated the debt of its banks, imposed capital controls, and told international investors to take a hike. Once again, this is a recipe for contagion yet systemic crisis did not result. Ireland did the opposite: it guaranteed the debt of its banks, did not institute capital controls, and paid off international investors. Systemic crisis also did not result. The opposite local policy response produced the same global outcome. Only the local outcome varied.

Contrast those cases (and all the other eurozone cases, and Argentina, and E Asia, and etc.) with the US in the Fall of 2008. A couple days of dithering -- of the sort that the eurozone has made its speciality -- lead to an immediate and profound downturn in global markets, including the largest single-day evaporation of wealth in absolute terms in history. The US tried to kick the can down the road, but couldn't because it is the core node; the EU has been able to repeatedly kick the can down the road because those crises are in the periphery.

I conclude from this that policy always matters locally, but it only matters systemically when the crisis is in a core node. No matter what the policy response to peripheral crises is, systemic contagion is exceedingly unlikely. I am prepared to hear arguments counter to this, but they must go beyond assertion or "I'd rather not chance it". Evidence is preferable, but I'd even countenance an evidence-free logical argument with a clear causal mechanism. These are every bit as rare as the claim that systemic outcomes depend upon local policies is common.

*Note that we're making it hard on ourselves by calling essentially every country but the US and UK "peripheral". This is not a common view (or was not prior to the crisis). Many thought that Iceland, Ireland, Cyprus, and other tax havens were significant global financial centers (or rapidly becoming so).  We're not talking about Somalia here... we're talking about OECD countries. Yes, we realize this is a bold claim. We think we have evidence and argument to support it.

**Remember that Spain was winning awards for prudential regulation a couple of years before the crisis. Ireland was held up as a model too. In the end that didn't help them.

All Networks Are Not Equal (and Financial Crises Are Not Viruses)

Many thanks to Henry Farrell for discussing some research co-written by a decent chunk of this blog's contributors, which was just released (and is currently ungated, thanks!) by Perspectives on Politics as part of an issue on inequality and the global financial crisis. It's been kicked around the internet a bit already, and already I've come across a major misinterpretation* of the central argument from Mark Thoma:

Are highly interconnected networks better at dispersing risk? It depends upon the type of risk. Suppose a toxin hits a network. If diluting the toxin across the network also dilutes its effects to practically nothing, then we want the network to be as large and interconnected as possible. When shocks hit they will be quickly diluted and rendered relatively harmless. But for toxins that are deadly in minute doses, toxins that kill whatever they touch even when they are highly diluted, we want the infected node on the network to be isolated as much as possible.

This is, we believe, the dominant view of financial contagion in the social sciences and in particular in international economics. In the paper we cite several different formulations of this view in the academic and policy literatures. If we reiterated this view it would not be noteworthy, and it probably would not be publishable. We think our article is noteworthy (and was published) because it argues that this conceptualization of risk in networks is fundamentally misguided: it places undue focus on the strength of the shock and the density of the network, rather than the location of the shock and the topology of the network.

To see the difference consider two shocks of equal strength which hit two networks of equal density. The only difference in the two networks is in the distribution of that density: in one of the networks the connections are distributed more or less equally -- most nodes in the network have about the same number of connections to other nodes -- but in the other network the connections are distributed very unequally -- a few nodes have a lot of connections, while most nodes have few.

We believe that we should expect very different outcomes from the same shock and the same overall density because of different distributions of connections. All networks are not equal. Outcomes do not just depend on the strength of the toxin, but whom it contaminates.

We show empirically that different crises have have different impacts on the global system: crises originating in the US have adverse consequences throughout the entire network, while crises that hit other places do not. We show empirically that the global financial network is highly unequal: it is centered around the US (as Farrell notes in the bit Thoma quotes). And we argue that it is this variation in the distribution of connections, which we call "topology",  which made the subprime crisis so severe from a global (i.e. "systemic") perspective. Or, as Farrell put it in his useful discussion:

Oatley et al. argue that you get two kinds of financial crisis in this kind of world. First, you get financial crises in the periphery, which tend to be limited to a particular region because few other countries are directly exposed to the countries undergoing crisis, and to fizzle out. Here, US dominance serves as a dampener – since it is large enough to absorb shocks itself, it can prevent financial contagion from spreading. In contrast, when a crisis occurs within the US, it tends to spread everywhere, since every other country is heavily linked to the US. When US mortgage markets sneeze, everyone catches cold.

I'd say that when the US sneezes everyone catches pneumonia. So in our view the question isn't whether the toxin is "diluted"*. Nor is it whether a denser network might be more or less capable of absorbing a shock. In our view the performance of the system in the face of a shock depends on the structural properties of the system, such as its topology, and the location of the shock within that structure: if it hits the periphery, the impact is narrow and remains in the periphery; if it hits the core, the impact is broad and emanates throughout the system.

This may seem obvious. We believe it is obvious, after you've read the article. Before you've read it (as Thoma obviously has not) you may end up writing things like this (as Thoma has):

We have been told that problems in places like Cyprus have been walled off -- nodes in the network have been isolated -- but so long as a few isolated connections still exist that are difficult to cut, highly toxic shocks can pollute the rest of the network. In addition, as we saw today when "Jeroen Dijsselbloem, the current head of the Eurogroup, held a formal, on-the-record joint interview with Reuters and the FT today, saying that the messy and chaotic Cyprus solution is a model for future bailouts" and financial markets reacted negatively (the statement is being walked back), some connections -- those involving expectations -- cannot be severed in any case.

Highly interconnected networks are highly desirable so long as (1) we can quickly identify trouble, and (2) nodes can be quickly and effectively isolated. But when those conditions are not present, the occasional highly toxic shock will cause quite a bit of damage.

Despite being the conventional view (here's another example, also from yesterday) we think this is totally wrong. We think that the ongoing collapse in Cyprus is unlikely to have a major effect on the global economy, just as the collapses in Iceland and Ireland did not have a major effect on the global economy: the effects were devastating for those economies, and had some impact on the few countries which were strongly tied to them (mostly regional partners), but did not advance outside of that. Indeed, as the eurozone crisis has deepened over the past few years, the world economy has gone from recession to growth and global financial markets have posted strong gains (esp in the West; less in the "Rest").

We don't think this is a coincidence. We don't think we have just gotten lucky. We don't think that we were saved by wise and prudential crisis management (does anyone?). We think crises in peripheral nodes are very unlikely to spread to the core of the system because of the structural properties of complex networks. We think, in other words, that the global financial network is not some abstract quantity, but something that can be modeled and understood.

Thoma says that markets "reacted negatively" yesterday. The S&P was off 0.33% yesterday -- a totally normal fluctuation -- after increasing by 4.3% over the past month, during which time the botched Italian election and worsening situation in Cyprus were supposed to send financial markets into turmoil. As I write this, European markets are up today.

So financial turmoil from Cyprus hasn't happened yet, just as it didn't happen last summer when the Greek crisis flared up. We wrote about that too, and said the same thing then as we're saying now, just as many economists and pundits argued then that we may be on the brink of doom just as they are now. We were right then and we're right now. Greece has defaulted at least twice since last May, yet the global economy hardly even notices. The Cypriot financial sector has essentially disappeared overnight (from a network perspective the links connecting that node have been effectively severed) and financial markets are up.

I'm being pedantic about this because the message doesn't seem to get across. The belief that a crisis anywhere can lead to a crisis everywhere is so ingrained that very intelligent people don't even recognize contradictory arguments with supporting evidence when they are quite literally staring them directly in the face, as Farrell's precis of our research (and link to the article) was peering through the monitor right into Thoma's cornea.

So I'm afraid I might have to be boring on this point until folks start internalizing it: all networks are not equal.

*Thoma doesn't explicitly assign this view to us, but he quotes part of Farrell's summary of our article -- which says something different from what Thoma says -- and then goes on to the bit I quite as if we were making the a similar case.

**In fact, we refrain from discussing viral contagion at all, as we believe it is not an appropriate analogy for financial contagion. We spent a bit of time discussing this in a previous draft, but as it was somewhat tangential to our main argument we eliminated it in the final version for reasons of space. The general point is that a virus can infect anyone it comes into contact with regardless of who that person is: a king is no less vulnerable than a peasant. Our argument is that not all financial crises are capable of infecting all nodes with which they come into contact. Most crises are not contagious at all, in fact. Our theory provides an explanation for that. But the virus language was referenced by both Farrell and Thoma, so I'll run with it for the purposes of this post.

If you incentivize it, will they come?

On Monday, I argued investment incentive policy is best understood within a political framework that takes seriously the electoral incentives state and local officials face. Looking through the New York Time's interactive database of investment incentives, it is striking how widely states vary in the amount of incentives offered. What explains this variation? One possible explanation is individual agency. Perhaps Texas has a very large incentive program because of the political influence of G. Brint Ryan; this is the implicit argument forwarded in the New York Times Investigative Series on Investment Incentives. Comparative political economists would point to institutional variation; differences in governance structures and how susceptible local governments are to corruption may explain the extent to which states pursue incentive programs.* Partisanship might matter too, although it is difficult to make the case that voters see incentives as clearly benefiting benefit at the expense of workers. Indeed, as I mentioned on Monday, experimental evidence suggests voters see incentives through the prism of job creation. This makes a partisan-based mechanism less plausible.

While people and institutions may help explain a portion of variation in incentive programs, I’d argue structural conditions are most important. (This probably won’t surprise readers of the blog – contributors here tend toward thinking about the world in such terms.) As I mentioned in Monday’s post, states and localities are working to attract jobs in a context of open capital markets. Consequentially, absent transaction costs, capital is mobile while labor is relatively fixed and this makes capital strong. Capital gets locational incentives because its exit option is credible. Labor, however, is captive so governments can tax it more. The problem with this view (besides the fact that suggesting governments face little pressure to reduce taxes on middle-class workers will get you laughed – and voted - out of Washington these days) is that the global economy, while open, is not frictionless. Transaction costs, or in network terms, negative externalities are important.

There is a large literature in economics on agglomeration effects – basically the idea that centers of economic activity form due to positive externalities generated by the success of a few enterprises.** In the 1950s, Detroit was perhaps the best example of one of these centers. Successful, large manufacturing enterprises require deep supply chains, preferably located with geographic convenience to reduce transportation costs and to decrease production times. Competitors often locate nearby to be better able to recruit management, design, and other knowledge workers. In network terms, when a fit enterprise center emerges, preferential attachment reinforces that center.

Today, thriving centers of economic activity in the US include New York City, the Silicon Valley, and perhaps even NC’s own Research Triangle Park. It is then not surprising that, according to the New York Times report, California is reducing its incentive program, which is already comparatively small at $112 per capita. New York and North Carolina have relatively low per capita incentive programs, $210 and $69 respectively. Compare that to the three largest incentive programs on a per capita basis – Alaska at $991, West Virginia at $845, and Texas at $759. Economic geography matters. The states with the largest incentive programs are those that either never generated large centers of economic activity, or whose centers have become obsolete as our economy has shifted from manufacturing to services.

Economic centers form due to a confluence of factors, some of which governments have control over and some that they don’t. Investments in education and infrastructure can provide a skilled workforce and inexpensive access to energy, telecommunication, water, and transportation networks. And, it is true that offering locational incentives may reduce governments’ ability to invest things that will actual increase their locality’s fitness. But, this ignores the fact that incentive programs are fundamentally designed undermine powerful network effects that concentrate economic activity. That is why they are so inefficient; because they are swimming against the current. Fitness is not the whole story – preferential attachment entrenches economic centers. So, incentives ultimately are big risks – if you are lucky, you may attract enough high-quality enterprises that you can build a thriving center. But, network dynamics are working against you.

* Nate Jensen pointed me to this particular NBER working paper , which finds evidence that corruption increases incentive programs.

**See here (firewalled) for a review.

Agreeing and Disagreeing with Kindleberger (and Delong and Eichengreen)

This post is basically to point to the new preface by Brad DeLong and Barry Eichengreen to Kindleberger's The World In Depression 1929-1939. I'm glad the book is being reprinted, and I am in agreement with all of DeLong & Eichengreen's intro. Except this part:

Kindleberger’s second key lesson, closely related, is the power of contagion. At the centre of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasise almost instantaneously.

I don't think this is "arguable". First things first... Creditanstalt was decidedly not a "relatively minor" institution; as Ben Bernanke has noted it was one of the largest (and most well-connected) banks in Europe. Moreover, it wasn't the first major bank to fail. To give just one example, the Bank of the United States (a private bank located in New York) failed in December, 1930 -- one of the largest bank failures in U.S. history, which occurred months before the collapse of Creditanstalt. Indeed, in his monetary history of the U.S. Milton Friedman considered the collapse of the Bank of the U.S. as the pivotal moment that tipped the U.S. from recession into depression. In general, financial instability in the U.S. seemed to precede financial instability in Europe from 1929 on.

The U.S. and much of Europe was already in depression before the collapse of Creditanstalt. Indeed, chronology suggests that Delong & Eichengreen have causality reversed: the Depression (combined with the fallout from losing WWI, including reparations) caused the collapse of Creditanstalt, not the other way around. U.S. industrial production had fallen by nearly 25% before Creditanstalt's collapse. Farms prices were down by 40%. The financial system was decimated. Trade was collapsing. The signal events occurred in 1929, not 1931. By the latter date we are talking about knock-on effects, not first causes.

My view is not particularly controversial. The collapse of Creditanstalt exacerbated a pre-existing panic, but it did not generate one sui generis.

Contagion is powerful, but it tends to operate from the center outward rather than from the periphery inward.* The best read of the collapse of Creditanstalt is that it was evidence of contagion rather than the epicenter of it.

That said, Kindleberger's book is very good in general, as is the new Delong/Eichengreen intro.

*We've blogged about this before, and we have a piece that will hopefully be forthcoming soon that makes this case explicitly. For a simplistic precis see this Foreign Policy piece that Thomas and I recently placed.

P.S. While thinking about this I stumbled across this piece from a 1952 issue of Time which gets nearly every detail wrong in its first paragraph. For starters: Creditanstalt collapsed in 1931, not 1929; it was not controlled by the Rothschilds until after that collapse; Hitler persecuted the bank during Anschluss for that reason, so it not quite fair to say that the bank "served" Hitler. The rest of the article is blocked to nonsubscribers so I (mercifully) can't read it.

The Importance of Actors in Networks

(Apologies for the light posting. Real work plus a family emergency has gotten in the way. Normal posting should continue for most of the rest of the summer.)

Ben O'Laughlin recently attended a talk given by Anne-Marie Slaughter to the British Parliament that focused on how the Clinton State Department is trying to lay the groundwork for perpetuating the U.S.-led liberal order. For those who have followed Slaughter's career, both as an academic and as a former senior advisor in Clinton's State Dept, the basics should not surprise. She's a strong advocate of leveraging networks to embed the U.S. at the center of the global system. She believes that one way to do that is via "smart power", a term coined by Joe Nye* and popularized by Sec. Clinton, that emphasizes persuasion as a complement to capabilities. What I found interesting, however, was the way that the State Dept is going about this:

Slaughter began by saying that structures are being put in place whose effects won’t be visible for some years. The structures the US is building are informed by the assumption that the biggest development in international relations is not the rise of the BRICs but the rise of society – “the people” – both within individual countries and across countries. The US must build structures that harness societies as agents in the international system. Slaughter returned to Putnam’s (1988) two-level game, the proposition that it is in the interaction of international and domestic politics that governments can play constituencies off against one another to find solutions to diplomatic and policy dilemmas. Slaughter took up this framework: the US administration must see a country as comprised of both its government and its society, work with both, and enable US society to engage other countries’ governments and societies. The latter involves the US acting not as “do-er” but as “convenor”, using social media and organising face-to-face platforms for citizens, civil society groups and companies to form intra- and international networks.

Critically, these two levels are flat. This took me by surprise. At the society level, citizens, civil society groups and companies are connected horizontally. No particular group or individual is afforded a priori centrality. Why is this a surprise? Public diplomacy experts have spent the last few years trying to target ‘influencers’ in societies. Influencers are political, religious or cultural figures who are listened to by others. This idea is informed by network analysis, marketing, and the idea that State Department messages are more credible in different parts of the world when mediated and delivered by a local influential figure than by Hillary Clinton on TV. Slaughter was not convinced by reliance on influencers, empirically or normatively. She argued that all the millions marketers have spent still hasn’t generated any clear knowledge about how influencers can be identified and utilised. Not only that, but it is surely preferable to try to engage whole societies and treat all individuals equally. That would flourish a greater democratic ethos than appealing to amenable clerics, companies, journalists and intellectuals in the hope they might spread the word downwards.

The bold is added and it's the part that I'm not sure about. A few lines up Slaughter says (via O'Laughlin) that she is "not convinced" on the empirical evidence that influencers are, erm, influential. I wonder why, because it as far as I can tell it's a pretty robust finding across many differential fields that use network analysis.** In network terms, "influencers" generally have a high "degree", meaning that they are at the center of the network and many other actors in the network are linked to them. In many cases, non-central actors are not linked in any way but through the central actor. So if you want to gain influence in the network you get the most bang for the buck by influencing the influencer.

Moreover, once established influencers tend to remain influential. This is because they are already influential. And influencers tend to become influential because of some intrinsic quality. Let's take an example. Bill Gates became influential because of his ability to make personal computing user-friendly and accessible, an intrinsic attribute. But once he gained an initial influence advantage he was able to gain even greater influence simply because he was already influential. This is not an intrinsic attribute of Gates', but rather what is called a "network externality". That is, one advantage of using Gates' products is that many other people are using Gates' products. So Gates attracts new followers largely because he has already attracted followers. In fact, Gates has been able to continue doing this despite the fact that his new products have arguably been inferior, relative to its competitors' products, than his early products. At this point Gates' position as an influencer is almost solely due to his position as an incumbent influencer.

How does this relate to Slaughter's program? It's all fine and good to engage everyone in the world with the U.S.'s message, to encourage everyone to think like stakeholders, and to try to build large coalitions that are broadly supportive of the U.S.'s interests (or at least are not reflexively against them). But this is a very high-cost, low-yield strategy. As O'Laughlin goes on to note, this is a very long-term plan with no guarantee of success. I'd add that if the U.S. cannot simultaneously get the influencers on its side then it is very likely not to succeed in buttressing the liberal order. And if the U.S. can get the influencers on its side then it is very likely to succeed whether it appeals directly to each individual in the world or not.

There's no reason not to do both, but a tactical change from targeting influencers to targeting everyone is misguided, in my view.

What I find interesting about this is contrasting Slaughter's approach with someone like John Ikenberry's. They have both spent their careers theorizing about the liberal order and the U.S.'s hegemonic relationship with it, and have co-authored a bunch of pieces on the subject, but seem now to have diverged in what they think about what needs to be done for it to persist. Ikenberry continues to stress the importance of international institutions, particularly formal institutions. Slaughter has also emphasized formal institutions in the past, particularly legal institutions, but seems not to be shifting focus. There is nothing contradictory about the contemporary work of Ikenberry and Slaughter, but they have diverged a bit in the points they've chosen to emphasize.

*I can use the diminutive because I met him once. That's all it takes, right?

**For one recent study in international relations relating specifically to advocacy networks, see this piece by Charli Carpenter.

The Coming Anarchy?

Ian Bremmer sounds the alarm:

Here are the two irreconcilable facts that shape the United States’ role in foreign policy: first, it is the world’s most powerful and indispensable nation, and will remain so for the foreseeable future, whether or not it is in decline; and second, the United States is unwilling to provide global leadership as it used to, because of domestic economic concerns and war fatigue stemming from two long campaigns in the Middle East.

This is where narcissism comes in. Focusing on the question of American decline is problematic because it means we’re applying an American lens to global problems. Whether or not the United States is in decline, the important thing is that in today’s environment, America is the last best hope for global leadership, which it is unwilling and unable to provide. The United States will not intervene on behalf of the Syrian people. It will not bail out Europe. It will not bomb Iran. These are the facts, decline or not.

This is, of course, a reference to Kindleberger's famous maxim of how the world descended into chaos during the period in between World Wars I and II: the British were unable to lead and the U.S. was unwilling to do so. The resulting anarchy was therefore a unnecessary tragedy which, according to Ikenberry, the U.S. learned from and was determined not to replicate following WWII.

Bremmer believes that that consensus within the U.S. has eroded and that there is no other global actor is ready/willing to step up to the plate. Here's Bremmer again:

Yes, this is absolutely the case. In the G–Zero, we see a combination of unwilling and unable leaders. The United States is dropping the baton of global leadership—and no one is willing to pick it up.

The implication is that, if this continues, calamity is likely in our future.

I'm in broad agreement with Bremmer in theoretical terms, but I don't see as much U.S. retrenchment as he does. The Obama administration may be many things but isolationist is not one of them. The foreign policy orientation of the party challenging Obama is not either. And while "there will be no Marshall Plan for Europe" this time, there is also less need for one. The Federal Reserve has taken many important actions to stabilize the global financial system, and it is not at all clear to me that intervening in Syria or bombing Iran would make the Middle East more stable rather than less. Nor is it clear to me that those options are truly off the table.

In other words, I think the last four years demonstrate that the current global order is actually remarkably durable. More durable than many believed. Global financial and security institutions have worked pretty well, or at least as well as they had previously. I see no reason to expect that to change in the next few years.

Partially because I think Bremmer gets the following wrong, even if I think he's thinking in the correct terms:

But political institutions need a big shock if they’re to be broken to pieces. The collapse of the USSR in 1991 wasn’t big enough; 9/11 didn’t cut it either. The financial crisis of 2008 proved to be the catalyst. So the question is, what comes next? Until the answer emerges, we are stuck with G–Zero—a transition period as the old order crumbles but nothing has yet replaced it.

I'm not actually sure the financial crisis was a catalyst for "creative destruction" (Bremmer's term, via Schumpeter) of the global order. It was a body blow, to be sure, but the structure of the system seems to have held. We haven't descended into anarchy yet, even if the residual effects are still percolating through. Moreover, the U.S. looks better positioned to remain central to the international system now than at any point since 2007 (or perhaps even earlier). So yes, there was a shock, but the center held, and now appears to be reinforcing itself. The wave appears to have crested, broken, and is now rolling back. So I don't expect to see the major changes that Bremmer does.

Why Is the US Doing So Well?

So asks Ezra Klein:

Not in absolute terms, of course. Unemployment remains high. Growth remains anemic. Markets remain shaky. But Europe has been doing something very close to imploding for months now. So just as our financial crisis sent Europe into a tailspin three years ago, you might expect that the possibility of a partial or complete break-up of the Eurozone would have American businesses taking a chainsaw to their workforces and households stuffing their paychecks under the mattress in the expectation that 2012 will be a lot like 2009. And yet none of that is happening.

He then runs down some data and has some quotes from macroeconomists. I think the answer is given by this interactive graph from the BBC. In short, Europe is much more highly exposed to weakness in the US (Above picture) than the US is exposed to weakness from Europe. Click on a few of those European countries; almost none of them expose the US. The ones that do -- mostly the UK -- are in decent enough shape. Even the biggest exposures, from France and Germany, are much smaller than exposures of European countries to the US, and of course the US has a much larger economy and banking system than any one of those countries.

Thomas, Sarah, Andy, and I have some joint research that we've posted about before that visualizes the same data in a different way. Ours includes more countries as well as cross-time developments, shown in an animation. (We posted it nine months ago, so the BBC is way behind.) The point is the same: the world is much more susceptible to contagion emanating from the US than the US is to contagion from the rest of the world. This includes even Europe.

In other words, it's not enough to simply say that interlinkages in the global economy are important, and conclude from that developments in the EU will automatically determine the US's economic performance. The patterns of interdependence are even more important, and these give us reasons to be optimistic that the US may be relatively okay even if Europe goes belly-up.

Review: Exorbitant Privilege

I read Barry Eichengreen's Exorbitant Privilege last night, whose subject is found in the subtitle "the Rise and Fall of the Dollar and the Future of the International Monetary System". From this, one might expect the bulk of the book to be a current discussion of the imminent fall of the dollar as the world's reserve currency, as well as predictions regarding what sort of system will replace it. This expectation is not well met.

As always, Eichengreen does best when he sticks to a narrative of economic history. There are two predominant strands here: chapters two and three, tracing the origins of the US as an international currency, from before the Revolutionary War until the collapse of the Bretton Woods system of fixed exchange rates in the 1970s; and chapter four, which recounts the series of economic and monetary integration regimes in Europe that culminated in the introduction of the European monetary union in 1999. Those two histories make up roughly the first two-thirds of this short book, the rest of which is dedicated to a discussion of the subprime crisis and other contemporary events.

The problem with the book is that there is no conceptual frame shaping Eichengreen's discussion. From the subtitle and many of the chapter titles (the euro's "Rivalry" with the dollar; the greenback's "Monopoly No More"; the specter of a "Dollar Crash") you might expect Eichengreen to be pessimistic about the future role of the dollar in the international monetary system. In the introduction Eichengreen sets the book up in this way, arguing on page 6 that "The conventional wisdom about the historical processes resulting in the current state of affairs – that incumbency is an overwhelming advantage in the competition for reserve currency status – is wrong". But the core of the book actually makes the opposite case: the role of the dollar as the pre-eminent global currency is likely to remain for the foreseeable future, both because of the attributes of the US as the world's largest economy, and because of the deficiencies of the only conceivable challengers.

Concerning the latter, Eichengreen spends the majority of the time on the EU. He also discusses Japan (no desire for the yen to be a reserve currency), China (no capability for the yuan to be without major reforms which would likely be destabilizing), other currencies like the Brazilian real and Indian rupee (not big enough, or global enough, economies or financial systems), and the IMF "special drawing rights" (SDRs, which among other criticisms are only used as accounting devices, and are not accepted by any private actors as a medium of exchange), but dismisses them in short order. He dedicates a long chapter to European postwar monetary history, some of which may be interesting to those approaching this subject for the first time, but all of which has been dealt with in more detail, and with more theoretical and empirical care, elsewhere.

Without making too much of a case, Eichengreen seems to suggest that the subprime crisis may be a catalyst for a shift in the global monetary architecture. His discussion of the crisis is not strong, either as a standalone discussion or as a means of linking it to the potential for a change in the global reserve currency. For example, near the beginning of this chapter he claims "At the root of the crisis lay financial irregularities unchecked by adequate regulation" (p. 98). At this point most observers acknowledge that this was the manifestation of the crisis, perhaps even the proximate cause, but not the root cause. Eichengreen seems to understand this a bit later on, when he discussions macroeconomic imbalances in the global system, the global savings glut, the US domestic political economy that led to low national savings and persistent budget deficits, loose Fed policy and the "Greenspan put", etc. All of these are deeper causes than the inability of banks or regulators to judge the extent of risk embedded in asset-backed securities, which, in this context, appear to be more leaf than root.

The end of Eichengreen's discussion of the crisis leads him to marvel that the strength of the dollar was reinforced as a result of the crisis, not weakened. This may also surprise a reader not already aware of this phenomenon, since all of the book until that point has set the stage for a rapid move away from the dollar following a crisis, similar in speed and precedent to the rise of the dollar in the immediate aftermath of World War I. The rest of the book is dedicated to a discussion of why that is unlikely to happen.

As a part of that explication Eichengreen reverses what he wrote earlier about the incumbency advantage. In the first chapter he wrote that arguing that the status quo is durable precisely because it is the status quo is "wrong". But later, on pages 124-126, he argues that the "advantage of incumbency" is "not to be dismissed". Then he hedges again, writing of China on p. 146:

That said, Chinese policymakers are serious about transforming Shanghai into an international financial center by 2020. Doing so will require deeper and more liquid markets. It will require liberalizing the access of foreign investors to those markets, which in turn imply other changes in the country's tried-and-true growth model. Liberalizing the access of foreign investors to China's financial markets will in turn require a more flexible exchange rate to accommodate a larger volume of capital inflows and outflows. While these are not changes that can occur overnight, it is worth recalling how the United States moved in less than 10 ears from a position where the dollar played no international role to one where it was the leading international currency. There is precedent, in other words, for the schedule that the Chinese authorities aspire to meet.

This should lead us to a comparison of the the world in the 2010s to that of the 1910s, and the relative positions of the US and China within those worlds. In the earlier period the largest economy (the US) was not the issuer of the global reserve currency as it is now. Despite that, it took at least one World War, and the subsequent collapse of the global economy during the interwar period, for the dollar to supplant the pound sterling. To reach undisputed dollar pre-eminence took another World War. The rapid shift in the dollar was therefore a consequence of the rapid shifts in the organization of global security and economic apparatus. As bad as the subprime crisis has been, it has not been anywhere near that scale.

Perhaps because Eichengreen does not have a clear conceptual framework with which to make sense of his history, his views about the future are wishy-washy: the "fall of the dollar" mentioned in the subtitle is not inevitable, nor even likely; then again, the rise of the dollar was rapid, and China's economic rise is rapid, so who knows?

A better approach, I think, would be to try to understand monetary dynamics in a network context. Eichengreen considers this briefly, in footnote 50 on page 151, only to dismiss it just as briefly. This is a shame. If he better understood network dynamics he might not write things like this, from page 8:

There may have been only one country with sufficiently deep financial markets in the second half of the twentieth century, but not because this exclusivity is an intrinsic feature of the global financial system.

But what if it is? What if the distribution of financial liquidity is power-law distributed? What if this introduces scale-free dynamics into the global financial network? This would imply that there is only room for one reserve currency at a time, and that currency is likely to remain in place until there is such a large shock that the network itself is destroyed, at which point a new network is constructed with a new currency at the center of it.

Such a shock occurred from 1914-1945. It has not occurred since, which is why the dollar's pre-eminence has survived less-major shocks like the collapse of Bretton Woods, the rise of emerging market economies, the monetary unification of Europe, the end of the Cold War, and the subprime crisis. Such a history might lead us to expect more stasis than change in the coming years, barring a systemic collapse on a level not seen since the interwar period.

Eichengreen does not spend much time in this short book on theoretical explanations for the nature of the global monetary system, instead choosing to trace several historical developments. This is fine, but it leaves us with more description than explanation, and so teaches us little about what to expect from the future.

Links

Some of these I may blog properly later, but time is scarce these days.

-- Ikenberry responds to Walt.

-- Good discussion of Herbert Simon and complex social systems.

-- Bernanke on how central banking has changed post-crisis, including on the interplay between regulatory and monetary policies.

-- Problems with Basel III implementation. This is what Jamie Dimon is referring to when he says Basel is "anti-American".

-- Vladislav Surkov, "Putin's Rasputin".

-- Interactive description of the eurozone crisis, as a series of weighted, directed networks. (ht Alex)

-- US attacks China's "Great Firewall" at WTO.

-- Ambrose Evans-Pritchard says world power is swinging back to the US. I hadn't realized it had gone.

New Research

On the Network Topology of Variance Decompositions: Measuring the Connectedness of Financial Firms Francis X. Diebold, Kamil Yilmaz
NBER Working Paper No. 17490
We propose several connectedness measures built from pieces of variance decompositions, and we argue that they provide natural and insightful measures of connectedness among financial asset returns and volatilities. We also show that variance decompositions define weighted, directed networks, so that our connectedness measures are intimately-related to key measures of connectedness used in the network literature. Building on these insights, we track both average and daily time-varying connectedness of major U.S. financial institutions' stock return volatilities in recent years, including during the financial crisis of 2007-2008.

This is important work, and I know that several regulators and central banks (including the Bank of England) are starting to take this sort of modeling -- weighted, directed networks -- very seriously. When you're trying to track sources of systemic weakness you really need to know what the system looks like. The problem isn't just "too big too fail", it's also about which firms are tightly connected to many other firms. These two will often correlate, but not always and not perfectly, so knowing the difference is important.

The Stock Market Crash of 2008 Caused the Great Recession: Theory and Evidence Roger Farmer
NBER Working Paper No. 17479
This paper argues that the stock market crash of 2008, triggered by a collapse in house prices, caused the Great Recession. The paper has three parts. First, it provides evidence of a high correlation between the value of the stock market and the unemployment rate in U.S. data since 1929. Second, it compares a new model of the economy developed in recent papers and books by Farmer, with a classical model and with a textbook Keynesian approach. Third, it provides evidence that fiscal stimulus will not permanently restore full employment. In Farmer's model, as in the Keynesian model, employment is demand determined. But aggregate demand depends on wealth, not on income.

I think some of this gets to my confusion about Keynesianism from a few days back. I think the last sentence particularly drives at what I was saying before: if the monetary multiplier is low because of expectations, then how can the fiscal multiplier be high under the same set of expectations? It makes more sense (to me) for behavior to be conditioned by wealth more than income, particularly if the income is temporary. I clearly need to become more familiar with Farmer's work.

And here's a near-complete preprint of Herb Gintis' most recent book, The Bounds of Reason: Game Theory and the Unification of the Behavioral Sciences. Via one of Phil Arena's commenters.

System Dynamics Remain Important

(click here for animation)

Via TC, a data point that reinforces some research that the IPE@UNC crew has been conducting:

MFIs in Europe have drained their bank accounts at European banks by about €700 billion over the past year and half, which at current exchange rates is approximately $1 trillion. It seems that much of that money has recently found its way into the bank accounts that European MFIs keep in US banks. And conversely, it seems likely that the large inflow of cash deposits held at US banks this year is largely from European banks.

Putting it all together yields a compelling story: European banks are shifting their cash assets out of European banks and putting much of them into US banks. This has happened at a significant rate, with a net transatlantic flow from European to US banks that probably totals close to half a trillion dollars in just six months.

Given all of the trouble in the US banking sector over the past four years, and given the recent S&P shot, why would foreign funds continue to flow into the US rather than, say, emerging economies that continue to grow at high rates? This sort of behavior is not expected by most political science, economics, or finance research or by many in the pundit and investing classes.

One answer may be found by examining the network dynamics embedded in the international banking system, one representation of which is above. (This graphs in-degree, which are bank holdings from country i to country j. Tie strength is the amount of holdings, node size is cumulative in-degree from all countries in the network.) The international banking network is highly unequal, with the US as the most central node in the system. Highly unequal networks have different dynamics than other networks, one of which is a "preferential attachment" rule for organizing links between nodes. The rule states that, because of network externalities, nodes that attract a lot of links will tend to attract even more links in the future. Thus, the structure of the network is stable and self-reinforcing.

The US has attracted by far the most foreign bank holdings throughout the entire data series, and the intensity of these links has increased (in nominal terms) over time. That process hesitated briefly at the height of the financial crisis before resuming. So given the structure of the network and the dynamics that that structure implies, increased flows into the US -- especially during times of trouble like those currently plaguing Europe -- is exactly what we should expect. If we didn't continue to see this behavior that's when we would need to start looking for major changes to the organization of the global economy.

Links

Probably won't get to blog these properly, but they deserve attention.

-- Sad that this is necessary, but Barry Eichengreen discusses why a return to the gold standard is probably impossible, and not at all desirable anyway.

-- "The network of global corporate control", a very interesting research paper.

-- "The Convulsions of Political Economy", an application of Marx to the current environment from an unlikely source: a Senior Economic Advisor at UBS.

Realism, Internationalism, and Networks

Henry Farrell characterizes the debate between Drezner and Slaughter as over "whether realism or networked internationalism best describes the basic contours of international politics" and thinks they're both wrong, preferring instead a view in which networks are important but that joint-gains functionalism is the wrong way to approach them: "If the kinds of international networked cooperation we see are all about struggles for resources, rather than achieving functionalist imperatives, then we may expect a very different international networked society than if these forms of cooperation are aimed at pursuing functionalist goals and Pareto-improvements". I read the debate, even more simply, as so:

Slaughter: Transnational networks are changing international politics by weakening or changing the role of the state, and this mostly leads to Pareto-improvements.

Drezner: Yeah, maybe, but states are still by far the most important actors in global politics and on many big-ticket items transnational advocacy networks have had little discernable effect. To the extent that non-state networks matter, it's largely because they change state preferences, not that they make states less relevant.

Farrell: Networks form for distributional reasons and states often cannot control them. In fact, states themselves are networks of politicians and bureaucrats. Networks transform politics via a complex process of contagion which is very difficult to predict ex ante.

Obviously some nuance is missing in these characterizations, but I think that's the gist of the argument. I have sympathy for all three views, but my own belief is that international politics operates somewhere in the space between Drezner and Farrell. That is, I think that networks play important roles in shaping international politics, but I think that their influence is best understood within the context of the state system. And despite the fact that international politics is comprised of a series of complex networks that interact, I don't necessarily think that "contagion" is the best way of thinking about these processes in all cases, nor that network behavior is a fundamentally mysterious phenomena.

Farrell and others cite the Arab Spring as a good contemporary example. According to one view, the "Arab Spring" is a "black swan" -- a rare event that is essentially unpredictable. I think Farrell would modify the Blyth-Taleb story about probability distributions into a network context, where "black swans" are now viewed as shocks to networks that diffuse through the system in idiosyncratic ways. In some cases the network may be transparent enough that we can predict how extreme shocks might affect the network, but in other cases we won't have that information, and anyway we can't know when or how the shocks will occur. In this view the Arab Spring is a phenomena that cascaded across state borders in a way that states could not understand much less control. Factor in social media and other coordinating devices -- which are networks themselves -- and it gets messy very quickly.

But the alternative view of the Arab Spring, which I believe is more or less the dominant view of those who study contentious politics, is that diffusion dynamics themselves are not enough to explain when revolutions succeed or fail.* Quite often it is the decisions of centrally-located actors that play the most significant role. For example, the Egyptian revolution succeeded because the military chose to protect the protesters in Tahrir Square rather than killing them, and because key international allies pulled support from the Mubarak regime. The attempted revolution in Bahrain failed because the state, with support from foreign allies, was able to mobilize the military to put the insurrection down. This story isn't about cascading network spillovers infecting international politics in chaotic ways, but about the ability of governments to do what is necessary to keep elites on their side. In Libya, the revolution was likely to fail without international intervention. In Egypt, international intervention was almost non-existent. But in each case there are clearly-identifiable actors operating within the network that are having an important effect on outcomes. In at least some cases their behavior may be predictable by either interest-based or ideational approaches.

Perhaps most significantly, to my knowledge there is no evidence that the Arab Spring is an internationalist movement rather than a series of local movements that have arisen somewhat idiosyncratically. Networks played an important role in organizing protesters domestically, but there didn't seem to be any similar network coordinating actors at the regional level, and not all Arab countries have experienced prolonged protest periods. This is what I was referring to above when I said that contagion stories can only take us so far. A contagion story would have to be able to explain why protests spread from Tunisia to Egypt and elsewhere in 2011, but not from Iran in 2009. Or why protests spread from Tunisia to Egypt to Syria but not to Jordan or Lebanon. Or why reforms in Morocco appear to have been accepted by the populace, while they were rejected in Syria. In other words, there appears to be plenty of room for some sort of two-step analysis when determining how, when, and why social movements diffuse through the system.

Which actors are the most important may be a function of network characteristics, but quite often the relative importance of different actors is knowable ex ante. As a critical central node in Egyptian society, no one was surprised when the defection of the Egyptian military tipped the scales in the revolutionaries' favor, and it seems that protesters believed early on that such a defection was likely if the crowds could sustain momentum for awhile. This belief provided just the motivation needed to sustain that momentum. Similarly, if we think about why the US financial crisis led to a global recession while the Swedish crisis in the 1990s did not, we can look to network characteristics of the global financial system and immediately see that the US is a much more important node than Sweden. We could then consult network theory that suggests that in highly unequal systems that are tightly inter-connected, networks are robust to shocks in the periphery but fragile to shocks in the core. Contra Farrell then, having a grasp of how networks behave and what the financial network looks like thus makes even complex phenomena like the financial crisis much easier to understand.

So on a fundamental level I'd argue that Farrell's claim that the international political system is best understood as "space for contagion" is missing something, at least under most common definitions of network contagion which tend to influence structure over agency. For one thing, as an empirical matter "contagion" often doesn't operate in ways we might expect. Revolutions are not viruses. Neither are neoliberal economic reforms or most other policies/outcomes that are often described in terms of diffusion or contagion. I'd rather say that we can use networks to understand the bargaining space within which strategic political actors interact. And if we understand how network dynamics confer power to some actors over others, then outcomes in international politics can be more easily understood.** The pattern of interdependence in networks is thus an important causal variable, but is not determinate on its own. Like Farrell (and Drezner), I do not assume that these interactions are necessarily Pareto-improving, or that they ordinarily will be. Unlike Farrell, I think that the role of states within these networks is likely to be substantial for all definitions of "state".***

Despite all of that, I think Farrell is much more right than wrong in emphasizing the ways in which networks affect international politics in ways not expected by most realist theory. And I think he's right to argue that Slaughter's focus on joint-gains functionalism is misplaced optimism in many cases. But I think the lesson from these corrections is not necessarily that international politics is a space for contagion to spread in unknowable ways, but rather that we need to situate political actors within a structural context to understand how they shape policy and respond to events.

*I'm heavily influenced in this by the research and teaching of UNC prof Graeme Robertson, who has written about and discussed the Arab Spring here and here. His current research is on contentious politics in post-Communist states.

**For one example of this see Charli Carpenter's recent IO article on gatekeepers in advocacy networks.

***In other words, depending on the analysis, we may need to complicate states along lines that Farrell suggests. Sometimes the subtle two-step that Drezner advocates will be fine. As Bear Braumoeller notes in comments to Farrell's post, endogeneity problems quickly emerge when you try to internalize everything into network analyses. Nevertheless Farrell is correct in saying that if we think of world politics as a complex adaptive system (and we should), then problems quickly emerge when we "black-box" any one level of analysis. Unfortunately there's no simple solution for this, but there are ways to gain tractability by shifting focus from one level of analysis to another without completely losing sight of the other levels.

S&P and Exorbitant Privilege

Layna Mosley, one of my professors here at UNC, has a guest-post at the Monkey Cage on the sovereign debt downgrade. I'm not going to excerpt much as it's worth reading in full, but I want to highlight a few things. First:

[O]n the basis of just its fiscal statistics, the U.S. would have been under pressure to accept an IMF program long ago. Of course, there are many differences between the US and the typical IMF borrower; the broader point is that the US can’t necessarily expect its “special” status vis-à-vis markets to persist indefinitely.

I think the "many differences" part is really key here, as Layna gets to a bit further down:

In the U.S. case, the fact remains that Treasury securities are a favored “flight to safety” instrument for investors worldwide. When risk acceptance and global liquidity is high, investors look for high-risk, high-return assets – equity offerings in emerging or frontier markets, for instance. But when risk aversion is high, investors seek out safe havens. Treasury bonds have long been such a haven, both for domestic and foreign investors. Many holders of U.S. government securities are official entities (such as foreign central banks), while others are private investors.

What other options do these safety-seeking investors have? There’s the Swiss franc. And there’s gold. Both have experienced surges in prices that come from the search for safe investments. But where else might investors go? Certainly not into euro-denominated instruments, given the continuing crisis in the euro-zone. And probably not into renminbi-denominated instruments; for all of the speculation that the dollar’s “exorbitant privilege” is reaching its end, don’t expect it just yet.

The US is different from other countries that might go on to a IMF program in a lot of ways, but most importantly because it can create the most important store of value in the world, and it can do so whenever it pleases. Ireland, for example, cannot. Neither can Greece or Thailand or Malaysia or even Japan. Gold is limited by quantity, which is why prices are through the roof. Swiss francs are limited by the small size of the Swiss economy and its lack of centrality in the global economic system. The dollar is not only the most-used and most-traded currency in the world, it is also embedded in the global economy in ways that other currencies are not.

The graph above was constructed with BIS data. (Just ignore the isolates like "OtherEMS" and "FRF", which aren't actually in the currency system anymore; I was too lazy to take them out before making the graph.) Node size represents the % of total global currency exchange in a country's currency, and tie thickness represents the (bilateral) size of currency exchange between two currencies. The US is obviously the most central node and is also the largest by far; Swiss francs ("CHF") are much smaller and only has ties to Europe and the US. For the rest of the world shifting out of dollars into the Swiss franc isn't even really an option. For that matter, neither is the euro or yen. Only the US dollar has a truly global reach.

Network externalities can be very powerful. If everyone in the world is using dollars as a medium of exchange, it makes sense for you to use dollars as a medium of exchange. And if you use dollars, then your trading partners and counterparty investors benefit from using dollars. This effect reinforces itself as it spreads through the international economic system. Self-reinforcing patterns are path-dependent in complex networks; it usually takes the destruction of the entire system to reverse them.

And since the US is the only country that can create dollars, it has a very important capability that countries on IMF programs do not: the ability to service its debts with paper, with a strong presumption that it will not be punished for doing so as long as network dynamics remain self-reinforcing. So far the lesson from the S&P downgrade is that those externalities are not only still in effect, but are intensifying.

In other words, the US's peers are not Greece and Ireland, or the countries involved in the 1990s Asian flu. The US's peers are not even France and Germany, which are large industrial countries but do not control the printing press. Nor even Japan, which is sustaining a debt/GDP of nearly 200%. The US has no peers, and this shows up in the bond market data (to be discussed in a future post).

Several times in her post Layna explicitly or implicitly references Barry Eichengreen, who has written a lot on capital, debt, and currency. In a recent column, Eichengreen argues two things. First, that the argument of his recent book Exorbitant Privilege is essentially wrong: the global currency system will not move to a USD/euro condominium in the near term, because "a pox has been cast on both their houses". Second, that there are no other viable alternatives in the form of national currencies -- he explicitly mentions the Swiss franc, Canadian dollar, Chinese RMB, and Australian dollar as being insufficient, despite being the main contenders -- and international baskets like the IMF's SDRs suffer from a lack of liquidity and over-exposure to the USD and euro. So he suggests moving to global GDP-indexed bonds. But this ignores politics. If Europe can't even issue Euro-bonds, and if SDRs are unattractive for a number of reasons, why should we think that a global effort will be more successful?

So I agree with Layna: the era of "exorbitant privilege" is not only not over, but this crisis has seemingly reinforced it. You don't hear much talk about "decoupling" these days.

Misc IPE Developments and Research...

... That I won't properly blog.

-- US and Mexico finally reach agreement on cross-border trucking. This issue has been festering since NAFTA's beginning, but came to a head a few years ago when Mexico got fed up and enacted retaliatory tariffs. To be clear: the US has been in the wrong here all along. Via Greg Weeks on Twitter, who also noticed Chomsky criticizing Chavez.

-- US, EU, and Mexico win case against China in the WTO over Chinese restrictions of exports of rare earth metals. China said the restrictions were for environmental reasons, but they were pretty clearly intended to benefit domestic manufacturers by subsidizing the price of an important input into production.

-- Brazil's real continues to rise, and they don't like it. Is this what adjustment looks like? And is it just me, or do all of Latin America's major economies look fairly fragile right now?

-- John Quiggin has an excellent series of posts [1, 2, 3] on what remains of Marxism if we ditch the assumption that revolution is both necessary and sufficient for positive social change. The answer, it seems to me, is very little that we can't get elsewhere. I've been thinking about this a lot lately, prompted by this awful book by Terry Eagleton (and even worse promo essay). I will probably be returning to the topic eventually.

-- Chinn, Eichengreen, and Ito do a "forensic analysis" on global macro imbalances in the run-up to the crisis. They aren't very optimistic about corrections in the near future. And Chinn describes an important-looking paper by Rose and Eichengreen on the effects of abandoning currency pegs for gaining policy flexibility elsewhere.

-- Tim Harford explains what all the fuss about bank capital is about. Excellent intro for those unfamiliar with the topic.

-- An aggravated take on the current US political economy of banking and bailouts.

-- The BIS compares the internationalization of the 2008 banking crisis, as compared to the 1931 banking crisis. The takeaway is that we only got a Great Recession (Little Depression? What are we calling this?) in 2008 because the lack of a gold standard allowed large liquidity injections.

-- Ha-Joon Chang and Jagdish Bhagwati debate the merits of a strong manufacturing base in The Economist. I wonder if the vote tally is a sign of the times? Ryan Avent adds some levity.

-- Cosma Shalizi reviews the new Easley-Kleinberg book on networks in The American Scientist. A free pre-print of the book is still available here (very large pdf).

Who Doesn't Love a Grand Theory Debate?

Well, me. Nevertheless, Nexon on Caverley, Caverley responds.

No deep thoughts from me, as I haven't read the article under discussion, but it seems that Caverley is arguing that neocons support democratization at least in part because it would weaken their (our?) enemies. Nexon argues that no neocons actually say that, nor do they have good reason to think it given their reliance on both neoclassical realism and some forms of (non-Wilsonian) liberalism, neither of which make that case. From where I sit that sounds right enough, and yet... even if neocons don't make that case, perhaps they should.

Academic IR writes all the time about how democracy can enfeeble states. And also about how it can strengthen them. Democracies supposedly constrain leaders by both making it difficult for them to go to war, but then make them try like hell to win once they get in one. Democracies are supposedly better are imposing audience costs, but that's a double-edged sword. Etc.

If we buy any of this*, then a statement like "democratization will strengthen states in some ways and weaken them in others" that is followed by a statement like "from the perspective of the United States vis-a-vis new democracies, the latter will usually out-weigh the former" is not implausible on its face**. Was Japan strengthened by post-WWII democratization, along with the economic integration that followed from it? I think so. Was Japan strengthened in its bilateral relationship with the U.S. by that process? Arguably no. It became completely dependent on the U.S. for its security, and to a large degree its economic prosperity. Relative to China, Japan got stronger. Relative to the U.S., perhaps not.

To think about it in another way: the neocon goal of a "league of democracies" would certainly have the U.S. as the most central node. Network externalities being what they are, the effect would be to reinforce American power. (Somewhat perversely, this isn't too far from Ikenberry's view.) It can then make an offer to other states: democratize and you'll get the benefits of being in the network, but only as a peripheral node. Such an arrangement could simultaneously increase America's relative power while improving material conditions for the new democracy. Thomas Friedman (does he count as a neocon?) would call it the "Golden Security Straitjacket". Speaking of the devil, Friedman has written a bunch about the benefits of authoritarianism.

So perhaps Nexon is right that neocons don't believe in "democratic enfeeblement". But maybe they should. It could follow from their other beliefs.

*I'm not necessarily saying we should. I hope Phil Arena chimes in.

**To be clear, Nexon doesn't argue that it is; only that Caverley's paper doesn't establish the claim that neocons actually believe this, despite using strange readings of cherry-picked texts.

The International Forex Network, 1998-2010

This weekend I got bored of cleaning some BIS banking data, so decided to play around with their foreign exchange data while watching the Cardinals beat up on the Cubs. There's less of those data, so it was easy to quickly get it cleaned and loaded into R. From there, I made the above graphs. The BIS only collects these data every three years, so the above visualizations represent the last five surveys, covering 1998-2010 (data here)*. These are bilateral ties, e.g. the USD<->EUR ties represent the nominal dollar value of all transactions between those two currencies. The thickness of the tie represents the amount of those transactions, divided by a constant (75) for all periods to make the visualization better. The size of the nodes represents the percentage of total forex transactions involving that currency.

These are quick-and-dirty. I used a simple Fruchterman-Reingold layout to emphasize centrality. Some currencies didn't exist for the whole series -- the euro in 1998; in later periods the franc, mark, ECU (XEU), and "Other EMS" which were rolled into the euro -- but I just gave them zero ties rather than spend the time to remove the actual nodes. (Hey, it's a weekend blog post.) The non-existent currencies are easy to see, as they are disconnected from the rest of the network. Just pretend they aren't there. Also, as I type this I realize that node size for "Other currencies" (Oth) is wrong because I inadvertently left some minor ones out, but the ties are correct and the node size wouldn't change by much since those are all small currencies.

Still, there's some interesting stuff to see. Most immediately obvious, the amount of foreign exchange increased noticeably from 1998-2010, as evidenced by the increasing thickness of the ties across the period. There was a 20% jump just from 2007-2010, which the BIS attributes mostly to technological improvements that lowered transaction costs and high-frequency trading.

Perhaps more surprising is the fact that the shape of the network has changed very little over the past dozen years. The US was the most central node, and the largest in 1998. The increased activity in the intervening years hasn't changed that at all. In 1998, the US was involved in 86.8% of all foreign exchange transactions**. In 2010, the number was 84.9%. The US's centrality (by this measure) peaked in 2001, when 89.9% of forex transactions involved the dollar. Similarly, despite much fanfare the euro has not moved to an especially central position. In 1998 the German mark (30.5%) and French franc (5%) were involved in 35.5% of forex transactions; in 2010 the euro (which absorbed not only the mark and france but other currencies as well) was one of the currencies traded in 39.1% of transactions. The yen decreased very slightly from 1998-2010 (21.7% to 19%), and the pound sterling increased slightly (11% to 12.9%), but in general the network changed very little. The Chinese yuan increased its share by 900% from 2004-2010... but was still on one side of less than 1% of forex transactions in 2010 (from 0.1% to 0.9%). This is shocking: despite all their growth over the past dozen years, in which their GDP has nearly quintupled, the world's second largest economy (third if we consider the eurozone as a collective, as we should for these purposes) is involved in fewer than 1/200 foreign exchange transactions. Nothing else changed much either. There are more thick ties in 2010 than there was in 1998, but all of them include the USD.

USD<->EUR transactions accounted for 28% of all transactions in 2010, close to its 2001 peak of 30%. USD<->JPY was second, with 14%. No other pair had more than 9%, and no pair that excluded USD had more than 3%. The extreme inequality in these relationships is shown by the fact that almost every currency in the network above is tied to the USD in all periods. Very few are tied to any others, short of EUR<->GBP and EUR<->JPY. China, in particular, is conspicuously weakly-tied considering the fact that it is the world's second-largest economy and it engages in so much trade.

There's been a lot of talk in recent years about a "post-American world", and the rise of a multilateral international monetary system to replace the US's "unipolar moment" in the 1990s. Several countries have spoken loudly about trying to displace the dollar as the world's reserve currency, replacing it with the IMF's SDRs or an international basket. These data indicate that such discussion may be premature. While it's possible that such a transition could happen in the future, there has been very little movement in that direction over the past dozen years. Given the fact that complex networks with an unequal topology have a habit of reinforcing themselves over time, we should qualify claims that the US dollar's role in international currency markets is in terminal decline.

*The BIS site says that there have been eight surveys, but the data I downloaded only had the five I present.

**Percentages in this paragraph, and this paragraph only, are out of 200% rather than 100% because each transaction involves a pair.

Using Network Theory to Understand Crises

(Click for larger image. The U.S. economy as a network, divided by sectors: Technology (blue), oil (dark gray), other basic materials (light gray), finance linked to real estate (dark green), other finance (light green))

Brandon Keim at Wired covered some new work in which researchers are examining the U.S. economy as a network in order to better understand the 2008 financial crisis and why it had such a devastating effect on the real economy.

From this analysis came two striking figures. The first is a map [above] of links between companies in five key economic sectors: technology, oil, other basic materials, finance linked to real estate and other finance. As of 2003, the sectors are relatively distinct, with real estate isolated. By 2008, they’re a tightly linked jumble, with finance at the center. ...

Other research on network dynamics has shown that interdependence can promote stability, but eventually reaches a point of reversing returns (see “Networked Networks Are Prone to Epic Failure“).

Much more at the links, so please click through. To me, there are two ways of looking at this. The first is the conclusion reached by Keim, that interdependence on its own can be stabilizing, until it reaches a critical mass, at which point increased interdependence destabilizes the system. Interdependence obviously went up throughout the 2000s. But another way to look at it is to examine the pattern of interdependence, rather than the occurrence of interdependence.

It is clear that the financial sector became much more central to the economy, so the economy as a whole became much more susceptible to trouble in the financial sector. In this way, the U.S. economy appears to display a feature of non-random, hierarchical networks, which is that they are robust to shocks in peripheral parts of the network, but fragile to shocks at the center. In other words, if a shock had hit the peripheral oil sector (as happened, in fact, in the middle part of the decade), the increased interlinkages with finance would make the economy more resilient. But once a shock hit finance, the central sector, everything else was prone to collapse as well.

All of us at IPE@UNC (plus Andy Pennock, who's on the job market this year, as hiring departments should note) are working on a project in a somewhat-similar vein, but in an international context. I'm sure we'll be blogging much more along these lines in the coming months. In any case, it's fascinating stuff and is being used more and more to try to understand the complex interdependencies in the global economy. The political implications of this work is also important, though I haven't much mentioned them here.

(ht: Josh Miller)

Weekend Links

UNC alum James Surowiecki on Chimerica and Chinese consumer spending

Employment Outlook for Humanities Ph.D.'s: Not Good

Jeffrey Goldberg shows that American airport security is a sham:

Airport security in America is a sham—“security theater” designed to make travelers feel better and catch stupid terrorists. Smart ones can get through security with fake boarding passes and all manner of prohibited items—as our correspondent did with ease.

World's Tallest Skyscraper - Burj Dubai - opens soon in the UAE

Pirate Stock Exchange in Somalia

James Fowler, Associate Professor of Political Science at UC-San Diego (he'll be on Colbert on January 7th) talks Social Networks with Will Wilkinson of the Cato Institute in this bloggingheads diavlog: