Tag Archives: economics

Resilience and Euro – diversity

On MacroEconomic Resilience ex-banker Ashwin Parameswaran draws upon Holling’s pathology of natural resource management and the work of Hyman Minsky (a connection I’ve mentioned previously and Ashwin has explored extensively – see here and here) to write about The Resilience Stability Tradeoff: Drawing Analogies between River Flood Management and Macroeconomic Management.

Ashwin Parameswaran insightfully writes:

In complex adaptive systems, stability does not equate to resilience. In fact, stability tends to breed loss of resilience and fragility or as Minsky put it, “stability is destabilising”. Although Minsky’s work has been somewhat neglected in economics, the principle of the resilience-stability tradeoff is common knowledge in ecology, especially since Buzz Holling’s pioneering work on the subject. If stability leads to fragility, then it follows that stabilisation too leads to increased system fragility. As Holling and Meffe put it in another landmark paper on the subject titled ‘Command and Control and the Pathology of Natural Resource Management’, “when the range of natural variation in a system is reduced, the system loses resilience.” Often, the goal of increased stability is synonymous with a goal of increased efficiency but “the goal of producing a maximum sustained yield may result in a more stable system of reduced resilience”.

The entire long arc of post-WW2 macroeconomic policy in the developed world can be described as a flawed exercise in macroeconomic stabilisation. But there is no better example of this principle than the Euro currency project as the below graph (from Pictet via FT Alphaville) illustrates.

Instead of a moderately volatile mix of different currencies and interest rates, we now have a mostly stable currency union prone to the occasional risk of systemic collapse. If this was all there is to it, then it is not clear that the Euro is such a bad idea. After all, simply shifting the volatility out to the tails is not by itself a bad outcome. But the resilience-stability tradeoff is more than just a simple transformation in distribution. Economic agents adapt to a prolonged period of stability in such a manner that the system cannot “withstand even modest adverse shocks”. “Normal” disturbances that were easily absorbed prior to the period of stabilisation are now sufficient to cause a catastrophic transition. Izabella Kaminska laments the fact that sovereign spreads for many Eurozone countries (vs 10Y Bunds) now exceed pre-Euro levels. But the real problem isn’t so much that spreads have blown out but that they have blown out after a prolonged period of stability.

Resilience and the Euro – networks

The New Scientist recently had an article by Debora MacKenzie on resilience and the Euro.  She writes:

… The diversity of a network’s components and the density and strength of its connections – called its connectivity – affect the system’s resilience, or resistance to change. More connections make a system more resilient: if one component fails others can fill in. But only up to a point. Go past a certain threshold and more connectivity makes the system less resilient because a single failure can cascade to every other component.

The trick is to get the balance right. “Cascades of failure may be controlled by changing the nature and strength of the links between various parts of the networks,” says Fisher. Much current research in complex systems focuses on assessing connectivity correctly to enable that. Other work aims to detect behaviour that indicates an imminent collapse.

So turning 17 separate currencies into one eurozone was a cascading failure waiting to happen?

Yes. That is why Greek debt is a crisis, even though Greece accounts for only 2.5 per cent of the eurozone’s GDP. News of its debts caused the trust that markets placed in Greek government bonds to plummet. Its creditors are mainly in the eurozone, so a Greek default is causing markets to lose confidence in other members, such as Italy – which is too big to bail out.

Could the crisis have been avoided?

Complexity theory shows what went wrong. Yaneer Bar-Yam of the New England Complex Systems Institute in Cambridge, Massachusetts, says his still-unpublished studies show that investors profited by driving down the value of Greek government bonds, triggering the crisis. And, he suspects, they have now moved on to Italy. If instead of national bonds issued by sometimes weak economies, the eurozone had one common bond backed by powerhouses such as Germany, such an attack could not have happened.

Germany rejects eurobonds. But, says Bar-Yam, complex systems such as multicellular organisms show that “if you are going to accept common risk, you have to invest in defences that extend to the weakest member”. Either that or make sure an attack on a weak member cannot spread, a technique that ant colonies have perfected: the death of a single ant has little effect on the colony as a whole. “Biology has solved this problem several ways,” says Bar-Yam.

The tragedy of a common currency

The current crisis of the Euro emphasizes some basic lessons from the study of resilience of dynamic systems. Attributes of complex systems that enhance resilience are diversity, redundancy and modularity. There is a cost of maintaining resilience. The decision to have one currency among different countries in Europe was based on a focus of efficiency. This could be reached as long as economies would grow steadily and the countries kept their budgets in check.

Unfortunately, some countries did not so. Also Germany and France have broken maximum governmental budget shortages, and no actions were taken. It sounds as if the basic principles of institutional design were not met. Meaning that there was no proper monitoring and were no proper enforcement mechanisms. Surprisingly there are not even regulations how countries may leave the EU or Euro.

By creating a tightly connected system without proper enforcement it is no surprise that the resilience of the European, and global, economy has been decreased. The budget crisis leads now to a spiral of distrust among participants in the action arena of the global financial system. It does not help either that the USA is not able to reach to any solution to their own budget problems.

If there was more modularity we could afford countries to fail. But in the tightly globalized financial system, a failure leads to a cascade of dominos falling. A short-sighted focus on efficiency has led to a costly endeavor and likely collapse of the euro. We can learn from long-lasting biological systems and the importance to develop system features that enhance resilience. Hopefully during the recovery after the pending transformation more emphasis will be given to design system properties to enhance resilience.

Analysis of impact of recent global crises on development

In the Guardian’s Poverty Matters blog Lawrence Haddad, director of the Institute of Development Studies (IDS) in the UK, writes What impact have the global crises had on development thinking? He summarizes some of the findings from an effort at IDS to assess how the financial, fuel, and food crisis of the past several years have shifted the assumptions underlying development.

Economic growth can be a force for good, but it does not have to be

When many of us were taught economics, growth was sometimes seen as sufficient for development and always necessary. [Our study] concluded that some kinds of growth are necessary, others irrelevant, and some harmful. Growth should be treated like technology: with the right governance, it can advance human wellbeing. The growth we want is economic development that is potent in reducing poverty, uses natural resources sustainably and emits significantly fewer greenhouse gases. Too much research on growth is focused on how we get it, rather than how we get the type we need. We get the growth we want by focusing on: creating the right initial conditions (such as low inequality); reducing entry barriers for new, small businesses; setting key prices at appropriate levels (as with carbon production); and adopting stronger transparency mechanisms to allow society to pressurise corporations.

Views on growth are surprisingly homogenous. This is probably because only one type of economics (neoclassical) is taught the world over. But monocultures, nature has taught us, are particularly vulnerable to events.

Wellbeing and resilience are not panaceas, but neither are they fads

The crisis impact work indicated that while material goods were very important to the human condition, so too were the relationships and the psychological dimensions of human existence. Wellbeing brings these dimensions together in an explicit way. The emerging concern with resilience of systems is perhaps a good thing to come out of the bad news of the crises. Given the new global uncertainties (climate, the emerging powers, and resource scarcities deriving from current lifestyles) we think these concepts of wellbeing and resilience are here to stay. But if used lazily to provide politically correct gloss to issues of measurement of progress and interdependence, they will become devalued.

Unfortunately the full study only seems to be available as a book.

Controversies around the Social Cost of Carbon

What is the social cost of carbon? That is,the monetary value of the long-term damages done by greenhouse gas emissions? Frank Ackerman from the Stockholm Environment Institute U.S. Center, recently gave a fascinating talk at the Stockholm Resilience Centre where he presented the widely used FUND-model, an integrated assessment model of climate change that links climate change science with economics. According to Ackerman, the interesting aspect with this model is not only that it is commonly cited by policy-makers in the US, but also that some of its basic assumptions, lead to quite bizarre results. The policy implications can not be overestimated.

As Ackerman notes in the TripleCrisis blog:

True or false: Risks of a climate catastrophe can be ignored, even as temperatures rise? The economic impact of climate change is no greater than the increased cost of air conditioning in a warmer future? The ideal temperature for agriculture could be 17oC above historical levels?

All true, according to the increasingly popular FUND model of climate economics. It is one of three models used by the federal government’s Interagency Working Group to estimate the “social cost of carbon” – that is, the monetary value of the long-term damages done by greenhouse gas emissions. According to FUND, as used by the Working Group, the social cost of carbon is a mere $6 per ton of CO2. That translates into $0.06 per gallon of gasoline. Do you believe that a tax of $0.06 per gallon at the gas pump (and equivalent taxes on other fossil fuels) would solve the climate problem and pay for all future climate damages?

I didn’t believe it, either. But the FUND model is growing in acceptance as a standard for evaluation of climate economics. To explain the model’s apparent dismissal of potential harm, I undertook a study of the inner workings of FUND (with the help of an expert in the relevant software language) for E3 Network. Having looked under the hood, I’d say the model needs to be towed back to the shop for a major overhaul.

A working paper that teases the critique in detail can be found here. To summarize the conclusions for non-economists: the social cost of carbon is way higher than $6 per ton of CO2….

Hirschman’s trespassing creativity

Economist Rajiv Sethi writes an appreciation of the great economist Albert Hirschman on his 96th birthday.  In The Self-Subversion of Albert Hirschman he writes:

Interesting lives make for interesting ideas, and Hirschman’s is a case in point. Born to a German family of Jewish origin in 1915, he was baptized (but never confirmed) as a Protestant. His education was in French and German, though he would later become fluent in Italian, and eventually in Spanish and English. By the age of sixteen he had joined the youth movement of the Social Democratic Party. Through his sister Ursula (who was a major influence on his life and thought) he met Eugenio Colorni, whose Berlin hotel room was used for the production of anti-fascist pamphlets and fliers. Ursula would later marry Colorni, and one of their daughters, Eva, would go on to become an economist in her own right and marry Amartya Sen. (Eva’s untimely death and her influence on Sen’s thought is acknowledged in the emotional leading footnote of this paper.)

Hirschman watched the rise of Hitler with increasing alarm, and fled Berlin for Paris alone at the age of 18 just a couple of months after the Reichstag fire. Over the course of the next few years he would live in France, England, Spain, and Italy. He spent a year at the London School of Economics in 1935-36, taking courses with Robbins and Hayek, but finding greater intellectual affinity with a younger group of economists among whom was Abba Lerner.

When war broke out in 1939 he joined the French Army and, for fear of being shot as a traitor by approaching German forces, was compelled to adopt a new identity as a Frenchman, Albert Hermant. By 1941 he had migrated to the United States, where he met and married Sarah Hirschman. (They have now been married for seventy years.) He joined the US Army in 1943, and found himself back in Italy as part of the war effort soon thereafter.

At the end of the war Hirschman returned to the US and was involved with the development of the Marshall plan. He subsequently spent four years in Bogota, first as an adviser to the government on development policy, and then as a private economic consultant. After a sequence of appointments at Yale, Stanford, Columbia and Harvard, he moved to the Institute for Advanced Study in Princeton where he and Sarah remain.

As far as methodology is concerned, Hirschman expresses “a dislike for too unilateral and uniform diagnoses,” preferring instead to imagine the unexpected:

Plutocracy in the USA: four views

1) From State of Working America an interactive graph of changes in average income and the top percentiles of US income.

From  1939 to 1973, during the 24 years from the start of WW2 to the first oil crisis the US’s average income grew by $30,500.  72% of this economic growth in incomes went to the poorest 90%, and 28 % went to the richest 10%.

Over the following 24 years, between 1974 and 2008, the US’s average income grew by $11,000 – average income of the poorest 90% declined, and all the growth went to the richest 10%, mostly to the richest 1%.

The data on the website comes from economist Emmanuel Saez’s work.

2) Economist Daron Acemoglu of MIT is interviewed by EconTalk about the role income inequality may have played in creating the financial crisis.

… Acemoglu suggests a simpler story where the financial sector through its political influence distorted the rules of the game, benefiting executives in the industry, which in turn led to outsized rewards and ultimate instability in the financial industry.

3) From the Washington Post Federal investigators expose vast web of insider trading.

“Given the scope of the allegations to date, we are not talking simply about the occasional corrupt individual; we’re talking about something verging on a corrupt business model,” Preet Bharara, the U.S. attorney for the Southern District of New York, said in a statement.

The heightened focus on insider trading by the Justice Department and the Securities and Exchange Commission comes as the financial crisis has shaken confidence in the honesty of the financial markets.

Far from being a victimless crime, insider trading takes advantage of honest investors. In a series of cases, financiers are accused of gaining – or avoiding the loss of – more than $100 million trading such familiar stocks as Google, IBM, Hilton and Intel.

“What’s at stake is the credibility of our markets,” said former Sen. Ted Kaufman (D-Del.), chairman of a panel Congress created to review the Treasury Department’s $700 billion bailout of financial companies. Insider trading, he said, “sends a clear message to people who want to invest in the United States that . . . I’m not going to get a fair shake in the market. And that’s very dangerous.”

4) Economist Robert Schiller is an expert on speculative bubbles. He was recently interviewed by the Browser and recommends five books about human behaviour, inequality and the financial crisis. Among other books he recommends Winner-Take-All Politics (mentioned earlier on Resilience Science). He says:

This is a new book – it just came out. It’s about rising inequality and it traces back to fundamental causes.

… In the US, we’ve seen a rapid concentration of wealth at the extreme high end. The top tenth of a per cent of the top hundredth of a per cent of the population is getting wealthy very fast. They point out that this is not true in Europe, and yet the economies are very similar and growing at similar rates. If the technology is the same, why would there be a difference at the extreme high end? And they argue that the answer is really political. There have been political changes in the US that allow the extreme high end to garner more wealth. Ultimately, it represents a failure of our society to take account of the fact that the extreme high end can lobby and can organise for its own interests, and we’ve let it happen.

Seed’s global reset on tipping points and systematic risk

Seed magazine has a special issue on new approaches to interconnected and complex challenges. It also features interesting articles on TEEB and ecological economics, new modes of science, forecasting, tipping points and systematic risk.  As well as,  Carl Folke’s article on resilience, which I mentioned previously.

Economist Ian Goldin writes on On Systemic risks

Systemic risk is the underbelly of globalization and technical change. Intense integration of markets, trade, and finance has accompanied the latest tidal wave of globalization, facilitated by seismic policy shifts, like those associated with the fall of the Soviet Union, the formation of the European Union, and the opening of emerging economies. Between 1980 and 2005, global foreign-investment flows increased 18 times, and trade flows increased more than sevenfold, reflecting unprecedented integration.

… While the term “systemic risk” has historically referred mainly to collapses in finance, recent decades of globalization have created new and broader risks. There has been an exponential increase in the number of nodes and pathways through which materials, capital, information, and knowledge can be transmitted at lightning speeds and with global reach. These networks also have the potential to create and propagate risk. Interconnectedness, networks’ central property, can lead simultaneously to greater robustness and more fragility. Risk can decline as connectivity increases because as risk sharing increases, so does the number of nodes and links. This is true of financial systems, manufacturing services, intellectual property, and ecosystems. However, increased fragility is also a concern. Once a tipping point is triggered past its threshold, connectivity can amplify and spread risk instead of sharing it stably.

Looming systemic risks include pandemics, which may spread more rapidly across a densely connected world, and bio-terrorism risks, which are likely to become increasingly systemic in the 21st century. The ability to produce biological and other weapons of mass destruction is becoming more widespread, especially among non-state actors, due to technological innovation (not least with the development of DNA synthesizers). Increases in population density, urbanization, and the growth of connectivity, both physically and virtually, means that dangerous recipes and panic can be instantaneously transmitted globally. And climate change, a silent tsunami that crept up on us, presents major systemic environmental, social, and economic risks to humanity.

In an article On Early Warning Signs of tipping points ecologist George Sugihara writes:

A key phenomenon known for decades is so-called “critical slowing” as a threshold approaches. That is, a system’s dynamic response to external perturbations becomes more sluggish near tipping points. Mathematically, this property gives rise to increased inertia in the ups and downs of things like temperature or population numbers—we call this inertia “autocorrelation”—which in turn can result in larger swings, or more volatility. In some cases, it can even produce “flickering,” or rapid alternation from one stable state to another (picture a lake ricocheting back and forth between being clear and oxygenated versus algae-ridden and oxygen-starved). Another related early signaling behavior is an increase in “spatial resonance”: Pulses occurring in neighboring parts of the web become synchronized. Nearby brain cells fire in unison minutes to hours prior to an epileptic seizure, for example, and global financial markets pulse together. The autocorrelation that comes from critical slowing has been shown to be a particularly good indicator of certain geologic climate-change events, such as the greenhouse-icehouse transition that occurred 34 million years ago; the inertial effect of climate-system slowing built up gradually over millions of years, suddenly ending in a rapid shift that turned a fully lush, green planet into one with polar regions blanketed in ice.

The global financial meltdown illustrates the phenomenon of critical slowing and spatial resonance. Leading up to the crash, there was a marked increase in homogeneity among institutions, both in their revenue-generating strategies as well as in their risk-management strategies, thus increasing correlation among funds and across countries—an early warning. Indeed, with regard to risk management through diversification, it is ironic that diversification became so extreme that diversification was lost: Everyone owning part of everything creates complete homogeneity. Reducing risk by increasing portfolio diversity makes sense for each individual institution, but if everyone does it, it creates huge group or system-wide risk. Mathematically, such homogeneity leads to increased connectivity in the financial system, and the number and strength of these linkages grow as homogeneity increases. Thus, the consequence of increasing connectivity is to destabilize a generic complex system: Each institution becomes more affected by the balance sheets of neighboring institutions than by its own. The role of systemic risk monitoring, then, could simply be rapid detection and dissemination of potential imbalances, much as we allow frequent underbrush fires to burn in order to forestall catastrophic wildfires. Provided that these kinds of imbalances can be rapidly identified, maybe we will need no regulation beyond swift diffusion of information. Having frequent, small disruptions could even be the sign of a healthy, innovative financial system.

Further tactical lessons could be drawn from similarities in the structure of bank payment networks and cooperative, or “mutualistic,” networks in biology. These structures are thought to promote network growth and support more species. Consider the case of plants and their insect pollinators: Each group benefits the other, but there is competition within groups. If pollinators interact with promiscuous plants (generalists that benefit from many different insect species), the overall competition among insects and plants decreases and the system can grow very large.

Relationships of this kind are seen in financial systems too, where small specialist banks interact with large generalist banks. Interestingly, the same hierarchical structure that promotes biodiversity in plant-animal cooperative networks may increase the risk of large-scale systemic failures: Mutualism facilitates greater biodiversity, but it also creates the potential for many contingent species to go extinct, particularly if large, well-connected generalists—certain large banks, for instance—disappear. It becomes an argument for the “too big to fail” policy, in which the size of the company’s Facebook network matters more than the size of its balance sheet.

Lin Ostrom’s Life After Winning A Nobel Prize

A fun NPR interview with Elinor Ostrom on Life After Winning a Nobel Prize:

KELLY: Now, to a Nobel of a more recent vintage. Elinor Ostrom won the Nobel Prize in economics last year for her analysis of economic governance. We’ve reached her in Bloomington, Indiana, where she lives and where she teaches at Indiana University. And, Professor Ostrom, how’s the last year gone?

Professor ELINOR OSTROM (Indiana University): Well, you have no warning of the heavy, heavy demands on you afterwards. It is a very great thrill to win a Nobel Prize, and I’m very, very appreciative. But I was not fully prepared for the amount of interest around the world. And I’m coping, but it’s been very intense.

KELLY: A lot of calls from people like us wanting to interview you and on speaking invitations, that type of thing. Is that what you mean?

Prof. OSTROM: Yes, yes. I’ve been receiving about 15 invitations a week, and I am no longer able to accept any talks during 2011.

KELLY: Wow.

Prof. OSTROM: And the accumulation for 2012 is piling up, and I’m going to have to tackle that in another couple of weeks.

KELLY: Well, do you enjoy doing this? It sounds like you’re traveling a lot, meeting interesting people.

Prof. OSTROM: Yes, I am traveling a lot, and I do enjoy it. But I also am teaching, and I have ongoing research and graduate students. And keeping up with it all is a challenge.

KELLY: Well, I have to ask, what did you do with the prize money?

Prof. OSTROM: Oh, well. We have a very, very active research center here at Indiana University. And our foundation is very responsible, so I gave the full sum to the Indiana University Foundation as part of an endowment to support ongoing research.

KELLY: You know, here’s one thing I wonder. Winning a prize as huge and prestigious as the Nobel could, I guess, influence you in a number of different ways. And I wonder does it, in some way, take a bit of the pressure off to have had your work – your lifetime’s work recognized at that kind of level? Does it take a bit of the pressure off in terms of what you feel you still have to do?

Prof. OSTROM: Oh, no.

(Soundbite of laughter)

KELLY: No?

Prof. OSTROM: I wasn’t aiming to win a prize. And so winning it doesn’t take pressure off in terms of future research. Colleagues and I have been puzzling about a variety of key issues. It’s a big challenge, and we’re still working on that.

KELLY: You were kind enough to speak to us last year when you won. And you are the first woman who won the Economics Nobel. I remember when we spoke to you last year, we asked you about that and whether this opens the door for more opportunities for women. Have you been able to see any of that come to fruition?

Prof. OSTROM: Yes, I think. I’m very pleased that women will not be facing the conditions that I faced where I was repeatedly asked why I needed education when I would be barefoot pregnant and in the kitchen.

KELLY: Oh, my.

(Soundbite of laughter)

Prof. OSTROM: So I think that phrase isn’t going to be repeated to current graduate students as frequently as I heard it.

KELLY: Good. Well, it’s been great speaking with you. Thanks so much, Elinor Ostrom.