How Was the Financial Meltdown of 2008 Like a Collapsing Ecosystem?
“It’s a jungle out there,” you might hear a big shot Wall Street type say about the high-stakes world of high finance. Yet, the jungle-ecosystem metaphor may be most applicable not to the competitiveness of the world’s financial system, but to its vulnerability.
For an unusual study in this week’s edition of the journal Nature, an economist (Andrew Haldane of the Bank of England) and a zoologist (Robert May of Oxford University) team up to argue that the banking and financial system is much like a natural system in the way that a key hit to one area caused the cascading wave of doom, which wrecked the world economy in 2008.
One way to see the resemblance is to think of the world’s many banks as the bean plants in a vast industrial mega-farm, where the nearly identical plants are all vulnerable to the same pest.
When a biological or social system is full of uniform individualsâ€”be they bean plants or banksâ€”one shared weakness can spell disaster for the whole lot. Even when a new beneficial trait or tool enters the picture, if all organisms adopt it, as many financial institutions did with credit default swaps and other risky trades that led to the financial meltdown of 2007-08, a tenuous balance can be quickly upset. [Scientific American]
Before the collapse, Haldane and May say, the financial sector believed that the high level of connectivity between financial firms was a way to lessen risk. No one firm was at particularly high risk, it was thought, which made it unlikely that any firm would fail. Yet little thought was given to the failure of the system as a whole.
Modern ecologists recognize that the failure of key species could cause non-linear, cascading ripples that cripple a whole ecosystem. And they recognize the threat of uniformity in a groupâ€”it makes it easier for any threat that arises to wipe out a whole group. But, New Scientist reports, banks didn’t recognize this when they all took on similarly high-risk financial products and their balance sheets began to look alike.
Bankers still think like 1960s ecologists, they say. Banks maximise their connectivity and similarity in an effort to increase stability, when in fact this may do the opposite. Pricing models for financial products called derivatives, central to the 2008 crisis, also wrongly exclude non-linear effects. May and Haldane think more ecological financial models might stave off another crisis. [New Scientist]
In the same issue of Nature, physicist Neil Johnson argues against extrapolating from a simple model to the complex worldwide financial system to freely. But, May notes, there are simple lessons that bankers could learn from nature.
“A lot of the mathematics that underpins derivatives and credit default swaps rests on often implicit assumptions on things that are like a balance of nature, ‘global equilibrium’. (But these) should be looked at in an analytical way rather than appealing to vague concepts such as perfect markets,” he said. [BBC News]
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