Tuesday, March 26, 2013

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

. Tuesday, March 26, 2013

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.


Ronan said...

I read the paper a while ago (when I found it online as a working paper, so it might have changed a little since then – and I can’t remember the specifics fully, so I’ll read it again) – but one question, is the US the only node through which a crisis can originate ie what about a regional crisis in Europe that affects the EU core, could that then trigger a system wide breakdown? (If you see what Im getting at)

Ronan said...

One more thing, can you carry the assumption of how a crisis emerges on a global level (ie only one originating in the central node will lead to a system wide breakdown) and apply it on a regional level (ie only a crisis emerging in a regional central node will lead to a regional crisis – crises in the periphery won’t lead to a regional crisis or one in the core)

Kindred Winecoff said...

"is the US the only node through which a crisis can originate ie what about a regional crisis in Europe that affects the EU core, could that then trigger a system wide breakdown"

While possible, we believe this is very unlikely. As in, it doesn't appear to have happened in recent history. Consider the Japanese crisis in 1994: even that wasn't enough to trigger a broader crisis, because it wasn't enough to take down the US (and UK).

As to your other point, we don't examine the question in any depth. But the Euro crisis suggests that there might be something to it. My suspicion is that the odds are somewhat low, but higher than a peripheral crisis infecting a global Core node.

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




Add to Technorati Favorites